Thursday, November 08, 2012

Why We Buy High and Sell Low

Making money in the stock markets should be quite straight-forward: Buy Low, Sell High. And, yet so many people fail to get it right. Statistics have shown that more than 90% of people who invest or trade in the stock market lost money. 

This point was brought up by a reader, Mat Cendana yesterday. To address his comment, I like to share the idea from an article written by someone called ShibaShake in Hubpages (go here). Shibashake explained that our poor performance in the stock market is the result of our lack of understanding of Stock Market Psychology. His idea may not be original as he made reference to a book written by Robert Cialdini. Shibashake's article is very good and I would recommend that you read it. I have summarized the gist of his and/or Cialdini's idea for your easy reading.

Robert Cialdini wrote a book entitled Influence: The Psychology of Persuasion, where he explained the reasons why people buy high & sell low in the stock market. 

1. Stock Market Psychology - Social Proof
It is human nature to look to others to determine the best course of action. If we look outside and see people carrying umbrella, we assume that the weather is bad and we too will carry an umbrella. If we see cars ahead start to change lanes, we will try to change lanes as well, in anticipation of an upcoming road block or an accident.

If we see others getting rich by buying stocks, then it must be a good time to buy. The same goes when everyone else is selling because we would assume that bad times are just ahead. This is also known as the Herd Mentality!! Because of this, we will be buying when demand & share prices are high and selling when demand & share prices are low.

2. Stock Market Psychology - Scarcity 

We all have a natural tendency of wanting things that are in short supply. The rarer an item is, the greater is its value because few will be able to possess it.  

Similarly, we will rush in and buy stocks at $10 because we are afraid that in a short time they will only be available for $12, $15, or much more. We must buy it now, because the stock may not be available at this price for much longer. That’s why when the stock market is rising, we feel a great need to jump in and buy.

According to Cialdini, there are two other factors that would exacerbate the effect of scarcity. They are loss and competition.

1. Scarcity and Loss 

I think we have all experienced this before in other areas of our life. We appreciate something more after losing it. It may be our girlfriends, our freedom or our money.

We like making money, but we hate losing money even more. This makes us most likely to buy when prices are high, because we have lost nothing and have gained much (at least on paper). On the other hand, we are not likely to buy when prices are low because we are afraid that we may lose more.

 2. Scarcity and Competition 

The other aspect of scarcity has to do with competition. When we are in direct competition with others for a limited item, the power of scarcity would kick in. This is when we must absolutely have it; not because we need it, but because we must not lose it to others.

When prices are high, we are most compelled to buy because that is the time when there is most competition for a stock. We must get it now before someone else gets it and makes money that should be ours. When prices are low, we are compelled to sell because we do not want to lose the opportunity of getting rid of our crap to someone else.

Cialdini suggests two ways to counter scarcity. They are:

1. Think before you act.

When we feel ourselves getting caught up in the emotion of the stock market, we must stop ourselves from buying or selling anything. Decisions that are made in haste are usually decisions that we will regret later on.

2. Item utility remains unchanged 

When we are swept up by the power of scarcity, Cialdini suggests that we remember this
The item we now want more than ever, has not fundamentally changed. The utility we derive from it also has not changed, just our need to possess it.
The points made by Robert Cialdini reveal much about ourselves, and shows us where we are most vulnerable to external manipulation.


Anonymous said...

hi!alex-good topic to bring out at this unstable time.I have been in the market since the klse was in 7th floor Bangkok bank and I am still learning.Sometimes I go up to Genting for 2or 3 nights and yet I dont place any bet.If I lost 2k I cant get it back.Whereas if I were to buy a particular stock even at high price I can hold and wait for it to appreciate and then sell.All these years I discipline myself to sell and let others make money from there.Be satisfied !I deem the stock market as a musical chair.It will stop and start again.Root of the problem.GREED !

Lip Yen said...

Hi Alex, thanks for sharing the article!

Mat Cendana said...

Thanks for the article and the link about something which I just can't put a finger to.

The statistics about 90% of people making losses eventually is scary. I don't know how accurate this is but from what I've seen and experienced myself, the number of failures is definitely high. One might make a lot of money initially but later would lose that plus a lot of his capital. The situation in the market is always dynamic with so many variables.

It's also fascinating that no matter how the general market is faring, there is always the opportunity to make money. Or lose it. Even during the Super Bull Run of the early-90's, and even when the market was clearly on an upswing, there are many who actually LOST money!

How could that be? Simply a case of "Buy high, sell lower" - even in a bull market, the upward movement isn't a straight line. They'd get fearful when the counter goes down and they sell "to cut loss". After a few days, it would go up again and exceed their buying price, meaning they would have made a profit had they waited. Do this repeatedly and the capital gets drained.

Investors would often focus only on fundamental and technical analyses which can be quantified in numbers and charts. But there are other factors and variables including crowd psychology that must also be taken into account. However, these are limits as to what we can research and analyse - some things we simply don't/won't know until they happen.

I feel the next-best thing that we can do is this - do our homework by researching the variables that we *can* analyse and then make the decision of what to buy and when. After doing so, sit back and just wait for them to perform and not be too influenced by the day-to-day movements. If one didn't buy at a historic high, often, it's patience and holding power that separate those who make profits and those who lose money in the longer term.

Alex Lu said...

Hi Mat Cendana

Well said. I like the part where you said: "do our homework by researching the variables that we *can* analyse and then make the decision of what to buy and when. After doing so, sit back and just wait for them to perform and not be too influenced by the day-to-day movements".

I think to succeed in the market, we must have the right balance of tenacity & flexibility. Tenacity comes from doing our own analysis & knowledge of the stock & sector. Flexibility comes from continuous learning & the humbleness of accepting new ideas or knowledge.

A few years ago, people were asking why the stocks of a certain sector (I can't remember which sector) were trading at lower single-digit PE. They were all raving by the attractiveness of these stocks & it turned out to be a value trap. Later, I read that cyclical stocks have the tendency to give rise to such 'mis-pricing' because the profit has reached a point where it is unsustainable & a pullback is eminent. The smart money would sell & sure enough the stocks would correct back sharply. I learned from that episode and I applied it to my calls on rubber glove stocks, shipping stocks & HDD stocks. We need to learn, unlearn & relearn to succeed in the market.