Four Steps to Avoid Buying High and Selling Low

Trading success has been said to depend more on your personal psychology of trading with respect how you lose than on what you make. That sounds pretty negative, but it is the advice given over and over by skilled, successful investors and traders. So what up?

Sure, you've heard the advice to cut your losses and let your gains run. Everyone has. Yet, who hasn't gotten that one just backward?

Buying at the top and selling at the bottom has to be the favorite way to lose money for most people. It is every investor's psychological challenge.

It's how the markets fulfill their apparent mission of making the most people wrong the most times.

Holding out hope that an investment or trading position will turn itself around and you won't have to take a loss is more common for most of us than cutting the loss early. Same with taking our money off the table when we start to get gains. (No one ever went broke taking a profit, right? Wrong!) Put the two together and you've got the pair of evil bookends that keep most of us from making significant money consistently.

If everyone really knows this, why do so many people fall into the trap?

Psychology 101 would have us think that since behavior that is rewarded tends to be repeated and behavior that is not rewarded or is punished tends to be avoided. If that's true, and I believe that it is, it doesn't seem to make sense that people buy at the top and get out at the bottom over and over and over.

The answer has got to be that we are repeating behaviors that are rewarding and avoiding ones that aren't. It's just that we are looking in the wrong places for the rewards and punishments. And, as best I can tell, the central issues center on how you cope with uncertainty and with timing.

The right side of any chart, be it in stocks, options, bonds, or commodities, is empty. It is painfully empty. Neither you nor I knows what's going to happen in the future and that gnaws at us. It is uncomfortable. It doesn't feel good.

Back to Psych 101, this is a situation ripe for a negative reinforcer to come along and offer us a way out. Negative reinforcement is not punishment. Rather it occurs when we are in an unpleasant situation and we have the option of doing something that makes it stop. If every time you walk out your front door a dripping gutter dumps water down your neck and you avoid it by going out the back door, you are more likely to go out the back door. Not getting water down your neck when you go out the back door is the negative reinforcement.

So there you are, not sure where the price of a stock is going next, not in because you aren't sure, unhappy because others are in and making money. Your basic psychological systems are screaming "get me out of this discomfort" and the most immediate way out is to buy something. Problem solved! (And once you're in, the whole thing works in the reverse.)

Problem solved in the short term that is. The existential angst if you will is right here, right now. The potential gain from sticking to our plan, the profit, is out there somewhere in the future.

From the longer term perspective by the time not being in the market got uncomfortable enough that you felt like you had to do something it was very likely too late and you got in near the top. The smart money was already taking money off the table. Then the roller coaster starts to reverse the process and it all happens over again in the mirror image. Hello red ink for us, the weak hands as the pros call us!

So, what to do?

The broad outline is pretty simple:

* Develop a trading/investing plan that takes a longer term view and limits losses while letting gains run.
* Expect your gut to try to get you to deviate from your plan.
* Have a set routine you go through when you feel yourself wavering from the plan.
* Focus your evaluations of how you are doing on how well you traded/invested according to your plan, not on the particular outcome.

Simple to say, hard to do, but it's what you have to do to elude the two-headed monster that causes us to buy high and sell low. Pogo hit it dead on when he said that "We have met the enemy and they are us."

John W. Clark is an individual investor with an interest in finding and exploiting the personal edges that come with each investor and trader's situation. He writes the StockSpinoffBlog that focuses on value investing through stock spinoff situations

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