Why Most Investors Overreact, Buy High and Sell Low

by Jeff Reeves | January 11, 2012 2:25 pm

AskTheEditor logo2 300x200 Why Most Investors Overreact, Buy High and Sell Low[1]“I really have to test your knowledge of behavioral finance,” Andrew wrote. ” Why is it that during losses sellers are aversive to sell whereas during gains, sellers are more encouraged to sell?”

That, my friends, is one of the great Zen koans for investors. I don’t pretend to know precisely how or why this occurs, but here’s a shot at an explanation:

It’s plain old human emotion that prompts folks to sell during a crash and buy at the top of a meteoric run — the very opposite of “buy low and sell high.” Here are the best analogies I can come up with:

On the sell side, it’s kind of like the fact that when you see a grizzly bear in the wilderness, Boy Scout guides say you’re supposed to stay calm and walk away slowly, but most folks run away screaming. They are too darn scared to think rationally.

Or put simply: Human beings are governed by emotions above all else.

Things get even more emotional when money is involved, too. More marriages fail based on financial disagreements than over anything else.

I suppose a better sell-side analogy would be that you are confronted by a grizzly and drop your wallet immediately. It slides down a hill into a pile of 10 other wallets from petrified campers like yourself.

Do you walk away, or run? Or do you retrieve your wallet? Do you take the time to grab the 10 other wallets that are at the bottom of the hill even if it means risking a mauling?

Which camper you are in this scenario has more to do with your upbringing and your lifestyle than your portfolio. It’s the rare person brave (or stupid) enough to stuff all 10 wallets in his pocket while a grizzly breathes down his neck. It’s also the rare trader who has the guts and wisdom to buy a true bottom or sell a true top.

But that’s why the 10 wallets are there to begin with, and why the opportunity even exists. If everyone seized the opportunity, it wouldn’t be nearly as profitable.

Of course, while sometimes it can pay to stuff your pockets in spite of the bear, obviously when things go wrong, they go very wrong.

Because sometimes it pays to run screaming. Consider the drop from $120 to $60 in Sears (NASDAQ:SHLD[2]) back in 2010 …  in hindsight, selling ASAP was mighty smart. Same for Netflix (NASDAQ:NFLX[3]) in 2011. Or Kodak (NYSE:EK[4]). Or Bank of America (NYSE:BAC[5]).

But whether you are running toward trouble or toward an opportunity is only evident after the fact. And that is the hardest thing of all.

Got a question for the InvestorPlace staff? Please send an email to editor@investorplace.com.

Jeff Reeves[6] is the editor of InvestorPlace.com. Write him at editor@investorplace.com[7], follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook. Jeff Reeves holds a position in Alcoa, but no other publicly traded stocks.

Endnotes:
  1. [Image]: http://investorplace.com/wp-content/uploads/2012/01/AskTheEditor_logo2.jpg
  2. SHLD: http://studio-5.financialcontent.com/investplace/quote?Symbol=SHLD
  3. NFLX: http://studio-5.financialcontent.com/investplace/quote?Symbol=NFLX
  4. EK: http://studio-5.financialcontent.com/investplace/quote?Symbol=EK
  5. BAC: http://studio-5.financialcontent.com/investplace/quote?Symbol=BAC
  6. Jeff Reeves: http://investorplace.com/2012/01/2012/01/2011/12/alcoa-aa-stock-limited-downside-high-upside-stocks-to-buy-in-2012/2011/12/2011/12/investors-can-learn-from-denver-broncos-tim-tebow/2011/12/gold-prices-new-record-2012-buy-gold/2011/12/2011/12/2011/11/2011/11/2011/11/market-rally-bank-stocks-financial-sector/2011/11/3-dividend-commodity-stocks-vale-scco-si/2011/11/2011/10/optimism-about-europe-debt-resolution-a-risk-to-market-rally/2011/10/2011/10/2011/10/no-bear-market-for-5-funds-etfs-slv-gld-thd-xrt-fdn/2011/10/author/jeff-reeves/
  7. editor@investorplace.com: mailto:editor@investorplace.com

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