Are you a victim of the trend?

After the stock market witnessed a historic bounce post elections, the number of emails that I receive with request for investment advice has doubled. What puzzles me is why people who want to invest in the market wait for the prices to go up before stepping in. It’s like waiting for the discount sale to end so that you can start shopping! Shouldn’t the inverse be true? If I am a net buyer of stocks until I near my retirement (I expect most people are), I would be glad if the prices stay down so that I can continue to buy cheap. In fact I would like all the appreciation to happen only after I reach the stage in life when I plan to stop investing and begin to encash my savings.

One reason people are eager to watch their stock prices constantly rise is because they are unable to bear their neighbours’ boasting about property appreciation. But there is a key difference between the two classes of investment — stocks and real estate. Most people buy property by taking a hefty loan — sometimes up to 85 per cent of the value of the property. The property investment itself happens on a lumpsum basis on day zero, although repaying the loan would continue for the next 20 years. Since the entire investment is done upfront, it pays for the appreciation to kick-in with immediate effect. On the contrary, when it comes to stocks, people don’t generally take a loan and make their total investment upfront. Instead they invest periodically over time to reap a lumpsum benefit after many years. In the event of a constant upward trend in stock prices, while you may earn high total returns on your early investments, the returns on your later investments would shrink. In fact the higher up on the upward trend line you invest, the lower your total returns.

But why do most people hesitate when they get an opportunity to buy when the market trend is down? Apparently, the culprit is “our brain”. Our brains are pattern-seeking organs and extrapolate every trend that they spot. When we see the market falling, we expect it to fall forever. Similarly when it is rising, we expect it to rise forever. And funnily the age of the trend makes this faulty reasoning even more pronounced and convincing. For example, if the market has continued to fall for many months, then we think it will definitely fall even further. Likewise, our confidence gains strength as the market rises and eventually reaches its peak when the market is at its peak. As a result, most people get caught in “perfectly bad timing” by waiting for prices to fall significantly before they sell or rise significantly before they decide to buy.

Another figment of our brain is “loss aversion”. Our hatred to experience a loss is more than our love for profits. So we are not even willing to suffer a short term notional loss by buying on the downward trend, although doing so would give an opportunity to reduce our average purchase price and increase our chance of “actual” profit when the trend reverses. On the other hand, we are perfectly okay in buying on the upward trend; despite the fact that this increases our average purchase price and exposes us to higher risk of “actual” loss should the trend turn direction (something that trends always do sooner or later).

I have seen many people get jittery when their stock does not increase the next minute after they purchase it. Let it fall a few points below the purchase price and they are petrified. Some quickly sell when the price breaches random stop losses while others just stay invested, cursing themselves. The latter group would either sell at rock bottom when they finally give up hope or wait for the trend to recover and reach a level close to the purchase price so that they can then sell for a minimal or zero loss. But isn’t the idea of investing to make a profit?

Here’s one more common behavioural quirk. God forbid, if the stock rises for two consecutive weeks after the purchase, people start thinking that they have cracked the code to the roulette table or something. What could be worse is that some of them start believing that they have acquired a special “skill” to invest, when the fact of the matter is “it’s not them”, “it’s the trend”. Misguided by the trend, instead of cashing out with the money, they either make new bets or increase the size of existing bets — at higher prices. “If I made 50 per cent in one month, imagine how much I can make in one year,” would be the governing logic. As you know, this is no logic but just rubbish, because most trends don’t last forever; even the one’s that do, go through many crests and troughs in-between.

What works best in stock investing is finding fundamentally good companies that have historically shown resilience in their business performance and buying them during bad times when the price gets beaten down, while adding to the position at lower levels. This way, instead of getting victimised by the trend, you can take advantage of it!