“…Well all my friends were doing it!”
“If all your friends jumped off a bridge, would you too!?!”
As kids, we all had some variation of this conversation with our parents, right?
So, as adult investors, we know that we shouldn’t blindly purchase a stock just because everyone else is, right? Unfortunately, no. Over time, individual investors consistently buy-high and sell-low, despite trying hard to do the opposite. The root of this trend is that, even after lectures from mom and dad, human beings find comfort in numbers.
“But Mommmm, everyone else is buying that stock!!”
This human nature is ingrained in all of us. Our ancestors were hard-wired to avoid predators (a loss) as a means of survival (self-preservation). A 21st century version of this instinct is still active in each of us. If you look out the window and see everyone wearing a jacket, you’ll probably grab a jacket before you leave the house. If you notice everyone at the basketball game turning left to exit the stadium, you’ll probably hang a left. If we stick with the pack, it’s less likely we’ll be singled out as “the loser”.
“What’re the chances all those people are wrong!?”
This pack mentality is the core reason individual investors usually buy-high and sell-low. When it comes to investing, the pack isn’t wrong…but by the time you catch up to them, it’s probably too late to save yourself. Whether your pack is a financial analyst on television, your “hot-stock-tip” neighbor or a trusted group of friends, they drive up the price of the stock as they continue to purchase it. Once you buy in, the stock is often over-valued (i.e., the price of the stock cannot be sustained by the company’s growth rate).
While purchasing this over-valued stock may provide you some short-term gains, sooner or later, the stock migrates to its fair value (i.e., what the stock is truly worth). By this point, your short-term gains are completely wiped out, and then some. As the stock falls below where you purchased it, your fight or flight instinct kicks in and you sell the stock to avoid losing all of your investment. At this point, despite ending in the red, you feel like you just jumped into a life boat off the Titanic.
Simple to understand, difficult to implement
Understanding the mental bias to buy-high and sell-low is one crucial step to successful investing, but it’s not enough by itself. Learning to evaluate the true growth potential of a stock, strategically using market movements to buy and sell them, remaining diligent to your, or your investment advisers’, plan and running free from the pack, when it’s called for, are some of the other elements needed to win the investment game.