Idea Of The Week: Why “Buy Low Sell High” Is So Difficult

This is a very good article talking about buy low, sell high. Many times we are driven more by our emotions than our judgement and how can we control that? 

Full article here: Fundsupermart

Emotions can hinder good decision making, especially when financial markets are turbulent

Having talked about some common investment pitfalls last week (see Idea of the Week: 3 Investment Pitfalls to Avoid [31 August 2012]), we further describe how emotions can hinder good decision making for investors, especially during periods of market turbulence.

BUY LOW, SELL HIGH

CHART 1: MUTUAL FUND FLOWS AND STOCK MARKET PERFORMANCE

Investors who follow the simple mantra of “buy low, sell high” are unlikely to fare too poorly in their investments. Nevertheless, many investors fail to adhere to this simple piece of advice, and often end up doing the opposite – selling low and buying high. As shown in Chart 1, investors have tended to do more buying when markets are high (with strong net inflows observed), while they do a lot more selling when markets tank (note the strong outflows from equity funds in 2002 and 2008). A key reason for this is that most investors tend to succumb to their emotions instead of making rational investment decisions. While investments are made on a forward-looking basis (eg. How much profits will this company earn next year, and the year after?), emotions depend very much on the status quo as investors become influenced by what they read and hear about in the news, which runs counter to logical investment decisions.

SENTIMENT AND MARKETS

CHART 2: INVESTOR SENTIMENT AND STOCK MARKET PERFORMANCE

Highlighting this high correlation between investor sentiment and stock market performance is Chart 2, which shows the “bulls minus bears” percentage of the AAII (American Association of Individual Investors) weekly survey compared against the S&P 500, a gauge of US equity market performance. A positive reading on the gauge is indicative of more bullish respondents, while a negative reading indicates that there were more bearish respondents in the survey. Historically, even as investors have generally been more bullish than bearish, they have tended to demonstrate high levels of negativity when markets were particularly weak, like in 2002 and 2008, which correlates with higher net outflows from equity funds over the same period.

AVOID THE HERD, FOCUS ON RATIONAL INVESTING

More often than not, being successful at “buy-low, sell-high” investing will require you to deviate from the crowd, and make “contrarian” investment decisions. While this can certainly be unsettling (especially when everything you read runs counter to your own investment decision), it can be an extremely rewarding experience. Articles like “Equity Markets at a Bargain, 13 Upgrades to Our Star Ratings! [29 Oct 2008]”, “The Singapore Market Is Nearing A Bottom [20 Oct 2008]” and “Panic Selling, Panic Buying? [15 Oct 2008]” which we wrote in the depths of the 2008-2009 global financial crisis to highlight the attractive nature of equity markets were received poorly by investors who were undoubtedly feeling rather bearish at the time. However, investors who took a more rational approach and considered the bombed-out valuations of global stock markets were well-rewarded in due course. By recognising that listening to your emotions when investing can be an innate weakness, you are taking an important step towards a more successful investment experience.