Behavioral Finance: Timing the Markets

Buy low and sell high.

At first glance, this mantra makes a lot of sense. Get something for a cheap price, then sell it to someone else at a more expensive price and pocket the difference.

Everyone knows this, but most people in the market end up losing money anyway, leaving only a select few who are able to make consistent gains. Let us call the losing majority group A and the winning minority group B.

So what is the difference between these two groups of people? There are two main differences.

1. Relying on the analyses of others

If you ask someone from group A how they decide when to buy or sell, chances are they are just following an analysis made by someone else. It could be the word of an analyst who wrote a newspaper article, or a family member who got a hot tip from a friend.

Although there is a chance that the analysis is sound, this first group will probably still end up losing money. Why? Let me give an example to answer this question:

Assuming the person from group A believes someone else’s analysis that stock Z is a good buy now at $1.60, when it is potentially worth $2.20. So they go ahead and purchase stock Z at $1.60. All good so far.

Then, a flurry of bad news hits: the job market turns bad, there is a terrorist bombing somewhere in the world and a certain country just conducted a nuclear test. So the stock market goes into free fall, taking stock Z with it. The stock price drops to $1.30.

Now what happens to the person from group A that bought stock Z? He panics. He begins to fear the market has entered the beginning throes of a recession, and that more bad news is on the way. So he sells at $1.30, thinking he has protected his principal investment amount from further losses.

It does not matter whether stock Z rises or falls after this point – the fact is that a loss of $0.30 was made. A loss that would not have occurred if the person had not bought stock Z in the first place.

So let us ask ourselves: Why did the loss happen?

If all we have is the word of some investment analyst or the hot tip of a friend, it is really easy to abandon the analysis when the market moves against us. This is because we did not take the time and effort to develop our own understanding and analysis of the investments we plan to make.

At the beginning, when the price is low but rising, we may give in to greed and buy at a price higher than the recommended price. We might do so because we believe there are sure-fire profits to be made. Going by the same principle, we might hold onto the stock even after it reaches the so-called target price because we feel it can go even higher. The higher it goes, the more profits we make, right?

Then, when the market does an 180 and the stock starts falling, our fear replaces our greed, and we sell way below the target price of the stock because we fear that the price will drop even more. This is one reason why people from group A lose money.

It should also probably be mentioned here that this irrational need to “get the best deal ever” is what causes group A investors to miss out on a lot of money-making opportunities. Now, what about the second reason?

2. Not understanding the importance of Behavioral Finance

What is behavioral finance? Simply put, it is the belief that most, if not all investors are ruled not by logic, but by emotion. What kinds of emotions? Fear and greed. (You may recall I touched on these two emotions in the earlier section.)

These emotions, combined with certain psychological bias, can make us (and the rest of the stock market) very poor investors. Failing to understand how these factors can undermine our investing is the second reason why people in group A lose money.

In this article, I will touch on two of the biggest psychological bias that can throw a monkey wrench in your ability to make money through investing.

2a. Herd Instinct

You have probably heard of this term before. Herd instinct, which originates from how herds of cattle move together, refers to a mentality where people think and act similarly to most of the people around them. In an investor setting, this means buying when everyone else is buying and selling when everyone else is selling.

If you apply the concept of herd instinct to the stock market, suddenly all those unexplained huge rises and falls in stock prices start to make sense: The market moves wherever the majority wants it to move. And if the majority are just following someone else… you get the idea.

2b. Confirmation Bias

You know how after you become interested in, let’s say red cars, you start seeing them everywhere? It is not that there are suddenly more red cars around – it is your brain that is noticing them more because you have attached a higher level of interest, and therefore importance to it.

Confirmation bias is an extension of this phenomenon, and can be summed up in the following phrase: You see what you want to see.

Let me give an investment example. Assume a person from group A has decided that stock Y is a great bargain, but he tells himself he should conduct research to get a more informed opinion before he buys.

So, he types in stock Y into Google, and out comes six articles on it. Three of them see stock Y as a good deal, while the other three point out certain critical weaknesses of the stock.

The investor is encouraged by the first three articles, and their presence combined with his initial slant towards buying stock Y makes him gloss over the remaining three articles that point out the weaknesses. He ends up buying stock Y and getting burnt when the stock collapses due to those very weaknesses he chose to ignore.

So far, I’ve talked a lot about group A and how their reliance on others and ignorance about how their emotions can sabotage their investing ultimately cause them to lose money. What about group B?

One might think that the common factor tying group B people together is knowledge of some arcane technique that promises assured profits. Of course, this is not true.

The first thread that defines this group is that they have formulated their own investment strategy. Some adopt a contrarian stance (meaning they always go against the prevailing market trend), while others believe in reading annual report figures to get a sense of a company’s worth. It doesn’t matter what the strategy is, what does matter is the fact that they have developed their own strategy on their own.

Why does this matter? Because the confidence in their own investment strategy is what allows them to hold fast to it regardless of what the market movements are like. Just because everything is rising doesn’t make their target stock a better buy than before. As some say, a rising tide lifts all boats. Similarly, just because everything is going downhill doesn’t necessarily mean it is time to abandon ship like everyone else.

In addition to that, group B people have a keen understanding of their own psychological bias, and have measures in place to prevent them from sabotaging their investments. A good example is George Soros, the master trader who keeps a journal to document his rationale for each and every investment decision he makes, so that he does not become a victim to his own emotions.

Conclusion

As I have espoused in many other articles, doing something without truly understanding why you are doing it is a big mistake. Going along with the crowd without knowing what you’re doing is almost always a bad idea. At the end of the day, it is your hard-earned money on the line. Learn to manage your emotions, and don’t forget the Golden Rule of Investing: Never lose money.

All the best with your investing journey, and subscribe for more investment articles! Or go to my main page to see the full list of articles published by The Thought Experiment!

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