Why people buy high and sell low

In short

A friend of mine once told me he sold every share he owned the week the market hit bottom. He was not foolish. He was scared, and that is a very human thing to be. You have probably felt the same pull when the news turns ugly and your account balance keeps shrinking. Many of us buy when things feel good and sell when things feel bad, and that habit can cost real money. One way people guard against it is to decide their plan while they are calm, then write it down where they can find it. Some pick a set schedule for adding money and keep it boring. Some check their account less often than their nerves want them to. Some wait a full day and talk with someone they trust before any big move.

The whole of it

What it is

I once watched a neighbor of mine, a good man with a good heart, buy a stock at the very top of a boom. Everyone at the barbecue had been talking about it. Nobody wants to be the one left behind when a friend is getting rich, and that feeling has a name. Fear of missing out is the itch to join a crowd because the crowd looks happy.

The other half of the habit is the opposite. When prices fell, the same neighbor felt sick to his stomach. He sold at a loss, just to make the feeling stop. Buying high and selling low is not a lack of brains. It is what happens when good people follow their feelings instead of a plan.

You are not weak if you have done this. You are ordinary, and ordinary is a fine thing to be. It helps to know the trap is there, so you can see it coming.

How it works

Let me tell you about the two engines under the hood. The first is loss aversion. That is the finding that a loss stings more than an equal gain pleases. Researchers Daniel Kahneman and Amos Tversky described it in their 1979 paper on prospect theory, published in the journal Econometrica. Losing a hundred dollars hurts more than finding a hundred dollars feels good. So when prices drop, the pain grows loud, and selling looks like a way to quiet it.

The second engine is herd behavior, which means copying what the people around us do. When prices rise, everyone seems to be winning. A rising price also feels like proof that the choice was wise. So we buy more, and often at the worst moment.

Put those two together and you get a cycle. Prices climb, and confidence climbs with them. We buy near the top. Prices fall, and fear takes over. We sell near the bottom. Then prices may turn around, and we watch from the sidelines, feeling foolish. It stings. It also repeats.

Here is the part that should comfort you. The feeling is not a signal about what to do. It is only a feeling. A fire alarm can ring when there is no fire, and your gut can do the same.

The numbers, and where to find yours

You do not need many numbers to understand this habit. You need a few of your own, and you can find them in a few places.

The first is your time horizon. That is how many years until you need the money. Someone saving for a retirement thirty years away has a very different clock than someone who needs the money next spring. Only you know your date.

The second is your real return. The return a fund reports for itself can differ from what you actually earned. The gap comes from when you added and withdrew money. Some brokerages show a personal rate of return, sometimes called a money weighted return, in their account tools. Check your own statement or your firm's help pages to see whether yours does. If it does not, ask the firm how it measures your results.

The third is your contribution schedule. If your employer offers a retirement plan, your pay stub shows what goes in each pay period. If you contribute to an IRA, the yearly cap is set by law, and the current figure is the current figure, which the official source publishes each year. Knowing your schedule shows you how much you are adding, and when.

For plain guidance on the basics, the investor education site of the Securities and Exchange Commission, called Investor.gov, is a good place to sit for an hour. It is free, and it does not sell you anything.

A worked example

Let me tell you about a woman named Marta. She earns 52,000 dollars a year and puts 3 percent of her pay into her retirement plan. Her employer matches that 3 percent. Here is her math, with every input shown. Three percent of 52,000 dollars is 52,000 times 0.03, which comes to 1,560 dollars a year from her. The match adds another 1,560 dollars. Together that is 3,120 dollars a year going in.

Now picture two versions of Marta. The first Marta panics in a bad year. Her account has grown to 10,000 dollars, and then a downturn drops it by 30 percent. Thirty percent of 10,000 dollars is 10,000 times 0.30, which equals 3,000 dollars. Her balance falls to 7,000 dollars. She sells everything and moves to cash. She has now locked in that 3,000 dollar loss.

The second Marta keeps her paycheck contributions running. Over the next year, she adds 3,120 dollars. Her account holds the same kind of shares, and they cost less per share than before. So each dollar she adds buys more shares than it did a year earlier. Whether the price rises or falls after that, no one can say. This example makes no forecast. It shows only that the first Marta locked in a loss, and the second Marta did not.

The difference between them was not smarts. It was a plan made before the storm, and the second Marta had one.

Where it goes wrong

I would be a poor friend if I told you a plan is a magic shield. It is not. A plan can fail in a few ways.

One is checking too often. If you look at your balance every day, you feel every dip. Each dip is a small vote for selling. Some people find that looking once a quarter is enough to stay informed without stirring up fear.

Another is a plan that is too clever. A complicated scheme is hard to follow when your hands are shaking. Simple plans are easier to stick with. People often describe the plain version as adding money on a schedule and watching what it costs. Fees come out of your balance, so they are worth reading about.

A third is changing the plan when it hurts. A plan that you drop the first time it feels bad was never really a plan. It was a wish. If your plan truly cannot handle a 30 percent drop, then it holds more risk than you can bear, and that is worth learning on a calm day.

There is also a cost to acting on impulse. If you sell in a regular taxable account, you may owe tax on any gain. If you sell inside a retirement account, moving money out early may bring penalties. The IRS explains these rules on its website at irs.gov, and I would read them before touching anything. Small print costs less to read than a mistake costs to fix.

Last, none of this means selling is always wrong. Sometimes you truly need the money. Sometimes your life changes. The trouble is only when fear makes the call and you never chose it.

Questions to answer before you leave this page

When do I actually need this money, and does my plan match that date? If prices fell by a third tomorrow, what would I do, and have I written it down? Who is one person I trust to talk with before I make a big move? How often do I check my account, and does that habit help me or hurt me? Am I adding money on a set schedule, or only when I feel good? What did I feel the last time I bought or sold, and was it a plan or a feeling? And what small step, taken today, would make the next stormy week easier to sit through?