If you went to the bank on a Friday afternoon to deposit your paycheck, and then when you returned to do the same the following Friday found that your balance was zero, would you deposit more money into your account?
The answer of course is that you wouldn't. In fact you would probably close your account that day and possibly sue the bank for the loss of your money.
But what if there was a twist on that scenario?
What if the manager at the bank gave you a long and detailed explanation about what happened to your money, and promised that not only would you eventually get it back, but that when you did, you would get it back with a profit? Would you then re-think leaving the bank?
These might seem like silly questions, because common sense tells us that this is a bad situation, one we would want to get out of as quick as possible. But investors often find themselves in similar situations in the stock market, and in those cases common sense often fails them, and they fail to act.
Think of the investor who is in a stock that continuously goes down, week after week. Every Friday they check their account, and like clockwork, it is always less than it was the previous Friday. Yet they continue to hold that losing stock, sometimes even going so far as to buy more.
They cling on to every piece of good news that comes out of the company and focus only on positive reports from analysts. They then use this information to justify continuing to hold the stock, even if price is telling a completely different story.
Sound similar to the bank story?
This is a strange phenomenon, unique to the stock market, where reasonable, level-headed people will abandon all logic and common sense, and act in a way that they wouldn’t be caught dead acting outside the market.
This is because almost everything about the stock market runs counter-intuitive to the way we have been taught to think about life.
Take for example buying a new car. We have been taught that the lower the price is the better. So we wait for discounts and sales to drop the price on the car of our dreams. Sometimes we will even buy a used car because we know how much of a discount that will afford us on the price of a new one.
This strategy is correct, because a car, just like most consumer goods, is a wasting asset. We don’t buy it with an eye to sell it to someone else at a later date at a higher price. We buy it for the utility and enjoyment it brings us while we own it and know that chances are we will sell it for less than it cost us.
However, a stock is not a wasting asset. It is a commodity that we want to sell at some point for a profit. And the only way someone will be willing to pay us more money for that stock is if it is in more demand on the day we go to sell it than on the day we buy it.
So buying a stock that is consistently moving down, meaning that it is out of favor with investors, doesn’t make a lot of sense. Instead you should be buying a stock that is moving up -- one that is gaining favor with investors.
The only time you should buy a stock that is going down is when it is pulling back short-term in an overall long-term uptrend. This is one the things that technical analysis is helpful in determining.
You will find that you’ll become a much more successful investor in the stock market when you can think differently, but still use common sense in that same way you would in other aspects of your life.