How to Invest in the Stock Market: Understanding Investor Psychology

buy and sell stocks - How to Invest in the Stock Market: Understanding Investor Psychology

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Stock market mentors often advise new traders to “buy low, sell high.” However, as most observers know, high prices tend to lead to more buying. Conversely, low stock prices tend to scare off rather than attract buyers. These patterns likely are better explained by an expert in psychology rather than one in finance since emotions drive many of these decisions.

Long-term success as an investor means recognizing and understanding patterns. However, if one looks for specific attributes and employs protection strategies, investors can make buy and sell decisions that can satisfy both one’s human psychology and the need to produce positive returns.

Investors Rarely Follow ‘Buy Low, Sell High’ Advice

Let’s be honest. Most investors know how to buy low and sell high. We know that finding cheap stocks usually involves finding the equity with the low price-to-earnings (PE) ratio close to single digits and a growth rate that at least stands in or near the double-digits.

We also can turn to mentors such as Warren Buffett. He will not give investors real-time updates on his purchases and sales. However, he explains many of his decisions after the fact. He also leaves us with memorable quotes about value investing. One quotes sums up the “buy low, sell high” mindset:

“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

Despite our vast resources, most investors do not apply this knowledge. They continue to bid the price of Amazon (NASDAQ:AMZN) and Netflix (NASDAQ:NFLX) higher despite the PE ratios that exceed 150. They also show little interest in Ford (NYSE:F) despite its PE ratio of around six.

Watch Stock Averages

In fairness, such disparities might be justified on the surface. AMZN stock doubled over the last 12 months. Ford stock fell by almost 10% in the same period. Such stock behavior engenders a powerful but dangerous psychological motivation for investors to buy high and sell low.

Many otherwise talented investors go broke following such emotions. Investors like Buffett who appear to buy low, sell high know this. They make even more money when strong, fear-based emotions motivate investors to sell to him at low prices. Mr. Buffett profits handsomely when negative emotions subside and stocks resume their move higher.

As investor John Bogle said: “Reversion to the mean is the iron rule of the financial markets.”

Despite short and medium-term trends investors should expect such a reversion to happen eventually. While predicting the timing remains difficult, investors can employ strategies to mitigate the dangers of both their pricey and their undervalued positions.

On an expensive stock, such an approach could work for an investor who knows a stock they own has become overvalued yet does not want to sell since it keeps moving higher.

Understanding ‘Puts’

For example, perhaps an investor who bought 100 shares of XYZ stock at $200 per share. If this trader worried about a crash in the next three months, they can insure their $20,000 position. This insurance comes in the form of a long put.

Puts give an investor the right to sell a fixed amount of stock (100 shares per put option) at a certain amount (called the strike price) for a given period. If this investor decides to insure his position over the next three months and such a put trades for $10 per option, he can insure the 100 shares at a $200 per share strike price for $1,000.

If the stock stays above $200 per share for the entire time, the option becomes worthless, and the investor takes a $1,000 loss on the put option. Should the feared crash occur, the investor can exercise the option and still sell his position in XYZ for $200 per share.

In such a case, this person nets $19,000 ($20,000 for the stock minus the $1,000 cost of the option). Without the option, a sale of the stock would have netted only the current price times 100 shares regardless of how fall the stock falls.

Also, if the loss happens well before the expiration date, the investor could sell the option itself at a premium and possibly profit from the falling stock price. Either way, owning the option greatly reduces the losses.

What to Look for in Cheap Stocks

Protecting a position for a stock bought cheaply would work differently. First, look for long-term profit growth. Over time, profit growth either forces the PE ratio lower or the stock higher.

In such a scenario, the stock price tends to rise in most cases. In the case of F stock, the PE ratio at six makes the stock less likely to fall. Indeed, the six PE stands below the long-term average for F stock and the S&P 500 as a whole. Hence, any increase in net income would probably drive the stock higher.

A second option would involve dividends. Going back to Ford, F stock pays a dividend yield of about 6% as of the time of this writing. Modest profit growth over the next two years may not bring buyers to the stock.

However, the 6% yield will still give the investor a return while waiting for profit growth to improve over the long term. Both strategies give investors a return even if the stock’s reversion to the mean remains years away.

Final Thoughts on Buying Low, Selling High

Trading strategies can make buying low and selling high both profitable and psychologically acceptable. Human psychology often drives the momentum of stocks. Such emotions often drive expensive stocks higher and cheap stocks lower. While history tells us a reversion to the mean will occur at some point, such a move could be years away.

However, long puts can protect from a price decline in an expensive stock. In contrast, low PE ratios and dividends in companies with growth potential increase the likelihood of returns on underpriced equities even in down markets. By minding emotions and increasing ways in which one can profit, investors can more easily follow this simple yet difficult stock market advice.

As of this writing, Will Healy did not hold a position in any of the aforementioned stocks. You can follow Will on Twitter at @HealyWriting.

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