In his book The Most Important Thing, Howard Marks discusses what happens in an investor’s psychology after buying a stock and it starts to drop in price. Here’s an excerpt from the book:
Let’s say you figure out that something’s worth 80 and have a chance to buy it for 60. Chances to buy well below actual value don’t come along every day, and you should welcome them. Warren Buffett describes them as “buying dollars for fifty cents.” So you buy it and you feel you’ve done a good thing.
But don’t expect immediate success. In fact, you’ll often find that you’ve bought in the midst of a decline that continues. Pretty soon you’ll be looking at losses. And as one of the greatest investment adages reminds us, “ Being too far ahead of your time is indistinguishable from being wrong.” So now that security worth 80 is priced at 50 instead of 60. What do you do?
We learn in Microeconomics 101 that the demand curve slopes downward to the right; as the price of something goes up, the quantity demanded goes down. In other words, people want less of something at higher prices and more of it at lower prices. Makes sense; that’s why stores do more business when goods go on sale.
It works that way in most places, but far from always, it seems, in the world of investing. There, many people tend to fall further in love with the thing they’ve bought as its price rises, since they feel validated, and they like it less as the price falls, when they begin to doubt their decision to buy.
This makes it very difficult to hold, and to buy more at lower prices (which investors call “averaging down”), especially if the decline proves to be extensive. If you liked it at 60, you should like it more at 50 . . . and much more at 40 and 30. But it’s not that easy. No one’s comfortable with losses, and eventually any human will wonder, “Maybe it’s not me who’s right.
Maybe it’s the market.” The danger is maximized when they start to think, “It’s down so much, I’d better get out before it goes to zero.” That’s the kind of thinking that makes bottoms . . . and causes people to sell there.
Investors with no knowledge of (or concern for) profits, dividends, valuation or the conduct of business simply cannot possess the resolve needed to do the right thing at the right time. With everyone around them buying and making money, they can’t know when a stock is too high and therefore resist joining in. And with a market in freefall, they can’t possibly have the confidence needed to hold or buy at severely reduced prices.
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