It is easy to understand the concept of a market working when prices are rising.
Some people have made money and are ready to get out, while others are just getting in the market after watching their compatriots make money. It is hard to understand the other side of the market.
In a down market, the people on the sidelines are watching their compatriots lose money and many of them fear that they will lose money as well.
The average investor tends to ride those trends. It is called the “herd mentality.” You want to make money like the others so you buy into a high market. You want to avoid losses so you stay out of a down market.
It is easy to see why people act that way but just because it is easy to understand doesn’t make it right. The people that go against the “herd” tend to do quite well over time. It is called “buying low and selling high.”
Everyone wants to do it but it is difficult to accomplish. All of your emotions are telling you to do the wrong thing at the wrong time and you are required to look past your feelings and do the right thing.
For years we in the business have looked at “contra indicators” to tell us what to do. Contra indicators tell you one thing, but mean something else.
The easiest example is the herd mentality. When everyone is buying, that can be a sell signal. When everyone is selling, that can be a buy signal. Forcing yourself to go against the group can be a very profitable exercise.
I remember the market crash of 1987 when the Dow Jones Industrial Average dropped more than 600 points in a day.
That was, at the time, the biggest one-day drop in history. The big story was the next day when the markets opened down again and it looked like we could be in for another record-setting day to the down side.
Computer trading programs were triggered to automatically sell stocks and there was a void of buyers.
The Dow fell another 200 points right at the open before a group of six buyers decided to bet on the market rebound and bought some call options on the Dow.
That move triggered computer trading programs to begin buying and the Dow rocketed back up.
There always is someone on the other side of a trade. The price may have to change in order to find willing buyers or sellers, but they are out there.
In early 2009 as the equity markets continued to drop, a reader asked me, “What if the Dow goes to zero?” He was serious – and he was scared. I told him that the Dow has never been at zero.
The first day the Dow Jones Industrial Average began to trade, it opened around 7. Companies have intrinsic value and as long as that is true, there always will be buyers and sellers.
The key to success is to know when to buy and when to sell. Often it is when the crowd is doing just the opposite.
Scott Reed is CEO of investment advisory firm Hardy Reed in Tupelo. Contact him at (662) 823-4722 or email@example.com.