Why it's so hard to Buy Low and Sell High

You may have noticed that some of the best advice is the most difficult to follow, such as “Neither a borrower nor a lender be” and “Buy low, sell high.” So often, we do the opposite of what we intend to do. Once you become an investor, psychology works similarly odd tricks with the mind. This excerpt from Robert Prechter’s book,The Wave Principle of Human Social Behavior, goes a long way toward explaining why it’s so difficult for people to go against the crowd and buy low when everyone else is selling and to sell high when everyone else is buying.

Excerpted from The Wave Principle of Human Social Behavior, 
Chapter 8

How can seemingly rational professionals be so utterly seduced by the opinion of their peers to the effect that they will not only hold but also change opinions collectively? Recall that the neocortex is functionally dissociated from the limbic system. This means not only that feelings of conviction may attach to utterly contradictory ideas in different people, but that they can do so in the same person at different times. In other words, the same brain can support opposite views with equally intense emotion, depending upon the demands of survival perceived by its primitive components. This fact relates directly to the behavior of financial market participants, who can be flushed with confidence one day and in a state of utter panic the next. As Yale economist Robert Schiller puts it, “You would think enlightened people would not have firm opinions” about markets, “but they do, and it changes all the time.”

Throughout the herding process, whether the markets are real or simulated, and whether the participants are novices or professionals, the conviction of the rightness of stock valuation at each price level is powerful, emotional and impervious to argument. Gustave Le Bon, a pioneer in the study of crowd psychology, said a century ago, “It were as wise to oppose cyclones with discussion as the beliefs of crowds…. Time alone can act upon them.”

Falling into line with others for self-preservation involves not only the pursuit of positive values but also the avoidance of negative values, in which case the emotions reinforcing herding behavior are even stronger. Reptiles and birds harass strangers. A flock of poultry will peck to death any individual bird that has wounds or blemishes. Likewise, humans can be a threat to each other if there are perceived differences between them. It is an advantage to survival, then, to avoid rejection by revealing your sameness. D.C. Gajdusek researched a long-hidden Stone Age tribe that had never seen Western people and soon noticed that they mimicked his behavior; whenever he scratched his head or put his hand on his hip, the whole tribe did the same thing. Says MacLean, “It has been suggested that such imitation may have some protective value by signifying, ‘I am like you.’” He adds, “This form of behavior is phylogenetically deeply ingrained.” Thus, another advantage of herding behavior is the avoidance of seeming difference in order to defuse an excuse to attack.

This tendency toward mimicry is hardly confined to Stone Age tribes. Psychology professor Irving Janis of Yale University, after studying the dynamics of group decision making in the modern political setting, concluded, “In general, the greater the number of those in the decision maker’s social network who are aware of the decision, the more powerful the incentive to avoid the social disapproval that might result from a reversal.” What’s more, “The greater the commitment to a prior decision, the greater the anticipated utilitarian losses, social disapproval and self-disapproval from failing to continue the present course of action and hence a greater degree of stress.”

That is why, in financial markets, when the best time to buy or sell is at hand, even the person who thinks he should take action experiences a strong psychological pressure to refrain from doing so. He thinks, if only half consciously, “When my neighbor or advisor or friend thinks it’s a good idea, then I’ll do it, too. If I do it now, and I’m wrong, they will all call me a dope, and I’ll be the only dope. I’ll be singled out for ridicule, which is not only agonizing but dangerous.” Pressure from, and influence by, peers, then, is at least one reason why most people cannot bring themselves to change from a bullish to bearish orientation or vice versa if to do so would go against the ideas of their associates and contacts. It also explains why a market or other social trend can continue for a long, long time and why financial valuations can become so extreme as to appear outrageous to those who believe that people ought to base their decisions upon some calculable fundamental value.