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February 23, 2022 — 11 min read

Why do most investors buy high and sell low?

Josh Pigford

Author

Josh Pigford

There’s a famous quote by world-renowned investor Warren Buffett:

Be fearful when others are greedy and greedy when others are fearful.

The quote above is another way of phrasing the idea to “ buy low and sell high.” But most investors do just the opposite. They buy high and sell low—even when they know they should do the opposite. Let’s break down how and why this happens.

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We all know the basic idea: when demand is high, prices rise, and when demand is low, prices fall. In the stock market, this tends to happen in cycles. When rising demand for a particular stock causes a bandwagon effect, more and more investors rush to purchase it, and the stock price goes up.

This behavior causes a chain reaction in which each investor buys the stock in question, hoping to sell it down the line for a profit after the price rises even further. Thus, as the price increases rapidly with more investors buying into the frenzy, the greed of investors escalates as well.

But eventually, the cycle reverses itself. When prices for a particular security are sky-high, any slight hint of negative news or macroeconomic changes can crash the stock price. Here, the chain reaction occurs in the opposite direction, wherein investors sell in a frenzy, which hammers the security price. As a result, most investors who got on later in the cycle book heavy losses, and any investors who haven’t bought the stock yet won’t touch it out of fear that the price will drop even lower.

This cyclical behavior is what Buffett’s quote warns investors against. He suggests that we should be doing the opposite, whether the investor bandwagon is buying (greed) or selling (fear). In Buffett’s mind, the best time to buy is when investors are at peak pessimism and the best time to sell is when they are at peak optimism.

So why don’t we do that? Why is it so hard to follow the wisdom of one of the richest and wisest investors that ever lived?

Comfort in crowds

We as humans are social animals, and it is easy to find solace in crowds. Our ancestors were social beings who lived in tribes and had a much larger chance of survival if they stuck together. This social structure made humans more formidable and less vulnerable to attacks from predators. Humans who strayed away from the tribe were weak and likely killed.

Our societies, cultures, markets, and interactions have become more complex in the last ten thousand years, but the structure of our brains has primarily remained the same. We still crave the safety of the tribe (crowd). So when we see our fellow investors all doing the same thing—all buying the same stock or selling it— we feel the pull to do it too, even if we know it’s not the best idea. It’s an emotional decision, not a logical one.

When the whole world is running towards a cliff, he who is running in the opposite direction appears to have lost his mind.

C.S. Lewis

The above quote is a perfect representation of the behavior of investors in financial markets. There was maximum optimism at the bubble's peak during events like the Dot Com boom and the 2008 financial crisis. If anyone had a different opinion, they would have been laughed out of the room. The same sentiments reversed during the subsequent crash, and investors displayed maximum pessimism at market bottoms.

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(Source: RIA)

In this podcast episode, Travis (our co-founder and certified financial planner) and Sophia (our community manager) discuss bear markets, risk tolerance, and how to keep calm when everyone else is freaking out.

A data-backed story on investor emotions

Let’s look at data from two significant events, the 2008 financial crisis and the COVID pandemic in 2020, to illustrate how investors behaved in those times of crisis.

Part 1 - The 2008 Financial Crisis:

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(All data involved in creating the graph is available here.)

The graph above shows the correlation between monthly inflows/outflows into equity mutual funds and their comparison with the price of the S&P 500 normalized so that the effects can be easily identifiable.

Just after January 2008, there were strong inflows of money into mutual funds (positive value for the blue line) at the peak of the housing bubble. This graph shows massive optimism in the stock market at the bubble’s peak.

However, after the market crashed in August 2008, investors withdrew money from mutual funds at huge losses. Even worse, they lagged the crash in stock prices by a small margin, which means that many investors liquidated their mutual fund portfolios precisely at the market bottom rather than getting out ahead of it.

Part 2 - The 2020 COVID pandemic:

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(All data involved in creating the graph is available here.)

The same phenomenon was observed during the COVID crash in March 2020. Investors pulled out a lot of money from the equity market via mutual funds just after the crash. The strange part about this crash was that the markets recovered relatively quickly. But even though the markets bounced back, still there were no large inflows of money into equity funds. (View complete data and analysis here.)

These findings show that many investors who liquidated their equity holdings in the COVID crisis did not reenter the market in the following months even after the market bounced back, which resulted in investors missing out on subsequent massive gains.

Why Investors Lost Out In 2008 and 2020

According to Buffett, even though it would have been difficult to do, the prudent investor in both situations should have been buying (greedy) while others panicked around them (fearful) and vice versa. However, most investors followed the crowd, being greedy (buying securities) while times were excellent but fearful (selling securities) as prices started falling (selling securities). It’s particularly telling to note that this fear extended past when the market began recovering, and these investors would have made significant gains if they’d been willing to buy again.

This scenario may be due to a couple of significant factors:

How you can buy low and sell high

Now that we know the mistakes most investors make and why they buy high and sell low, we can look for ways to combat this behavior. And since most decisions to buy high and sell low are driven by emotions like fear and crowd-following, the best ways to do the opposite involve logic and rational behavior.

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