Two of my favourite things are investments and motorcycles. The other day I realized that the stock market and riding a motorcycle have something in common.
In order to turn a corner at speed on a motorcycle you need to counter-steer. Counter-steering is a pretty weird idea when a person is learning how to ride a motorcycle. It is the exact opposite of what you might expect needs to be done.
Think of riding a bicycle. If you want to turn right, you steer around a corner by turning the handlebars to the right. The right handlebar will come towards your body.
Riding a motorcycle requires the opposite actions. At speeds over 20 kilometers per hour centrifugal force takes over and the motorcycle acts like a big gyroscope. What this means is that in order to turn right you will actually push the right handlebar away from yourself. To turn left you must push the left handlebar away. Push right, go right. Push left, go left.
Riding a motorcycle requires action that is opposite from what initially seems natural. Similarly, being an investor in the stock market can require action that is opposite to a person’s initial natural reaction.
Two of the most common mistakes that investors make are to buy high and to sell low. The funny thing about this is that some people recognize the folly of these investment traps, and yet rush in to do it anyway.
Let’s take the first mistake, buying high. Making money is a very tough thing to do to if you buy high. Unfortunately, it happens all the time. Let’s say your buddy tells you about a stock that has just zoomed up. Often people react to this news by wanting to buy some for themselves.
It is true that one possible outcome is the investment will continue to appreciate. However, the simple and undeniable truth is that if the investment has already soared, it probably will dip sooner or later. It doesn’t matter how much money your buddy made, or how smart he is, or how much time he spends researching investments. Investments that grow by seventy or eighty per cent per year do not do so indefinitely.
Let’s take the second mistake, selling low. Investing requires patience. There have been lots of times that a person’s mutual fund has declined immediately after a purchase. Usually people realize that this can happen, and just leave things as is.
Sometimes, however, a person will see an investment go down, and they will panic. They may think to themselves ‘ouch, I just lost ten per cent, I better get out before it’s too late.” What they have just done is crystallized their loss by selling low.
Sometimes it does make sense to get out of an investment, but that’s not what I am talking about here. There are legitimate reasons to cut your losses, but I am talking about the commonplace mistake of a person with a long time frame selling a high-quality portfolio because of some temporary market volatility.
A person makes money by buying low and selling high. However, it is a natural reaction to do the opposite- to buy high and to sell low. Just like counter-steering a motorcycle a true investor will do the opposite of the natural initial reaction.
When markets are down, don’t sell. Look to pick up some wonderful investments at bargain prices. When markets are high, don’t buy.an investment at an inflated price. There are plenty of opportunities out there, and it is not necessary to pay expensive prices for average companies.
In the end it’s pretty simple. If you buy high and sell low you lose money. To maximize your chances of a successful investing outcome you must avoid both parts. Don’t buy an investment that has recently experienced unsustainable levels of growth. Don’t jettison an investment because it is temporarily out of favour.