Buy low, sell high. Investors understand this basic goal of investing. This idea appeals to the intellectual side of our brain. However, it is the emotional, not the intellectual, side of our brain that usually motivates action. That is why advertisements and sales pitches appeal to our feelings more than our intelligence.
Unfortunately, our emotions and psychological biases make buying low and selling high difficult. Consider the actions of many investors. The great bull market of the late 1990s brought millions of new investors into the stock market. The continual rise of the stock market was a trend that investors projected into the future. Assuming a past trend will continue is a common psychological bias. Since the stock market was rising, people believed it would continue to rise. As a consequence, investors put more and more of their savings into the stock market. Since the stocks of small technology firms were rising the highest, those were the stocks that investors bought. Many investors buy into stocks toward the end of a long bull market. That is, they buy high.
After a savage bear market began in 2000, millions of investors began to bail out. The print and broadcast media have been full of stories of investors who have thrown in the towel. These people feel betrayed by the corporate system and the stock market. Investors view the declining stock market as a trend that will continue into the future. So they sell. They sell low.
The same psychological bias that causes investors to be too optimistic near the end of a bull market also causes them to be too pessimistic near the end of a bear market. The bias that causes people to project the current trend into the future also causes them to do the exact opposite of what they intellectually know is the goal. They buy high and sell low. When the stock market was at its highest in 1999, investors couldn’t buy enough of it. The stock market went on sale in the summer of 2002 and investors didn’t want any part of it.
If you make investment decisions based on the emotional side of your brain, you usually end up doing the opposite of what the intellectual side would do. How do we avoid acting on emotion and psychological bias? One way is to use mechanical trading techniques that remove emotion from the process.
Judge the outcome of the time-tested technique of creating an asset allocation and then rebalancing it once per year. Consider an investor who targets a portfolio of 50 percent stocks and 50 percent bonds. Each year in the late 1990s, the stock portion of the portfolio did quite well and skewed the portfolio to be 60 percent stocks and 40 percent bonds. At year end, the investor sells some stock and uses the money to buy more bonds in order to rebalance back to the 50 percent stocks/50 percent bonds target. As the bear market began in 2000, bonds outperformed stocks. This investor would rebalance annually by selling some bonds and using the money to buy stocks. The technique causes investors to be selling stocks near the end of a bull market and buying them at the end of a bear market. The investor would have been taking profits in stocks in 1998 and 1999, and adding to the bond position just in time for the large 2000 to 2002 increase in bond prices. As the bond prices rose, the investor would then be taking those profits and buying into a depressed stock market.
In other words, the investor would buy low and sell high.
John Nofsinger is professor of finance at WSU and author of Investment Blunders (of the Rich and Famous) and What You Can Learn from Them (Financial Times/Prentice Hall 2002).