Why Investing Makes Smart People Feel Stupid

According to AMG Data Services, which tracks the flow of funds into and out of different categories of mutual funds (e.g., equity, fixed income and international), for the third quarter, a record $51.1 billion was drawn out of equity funds, both U.S. domestic and international, and a record $43.5 billion was deposited into bond funds.

What happened in October? Equities rallied and bonds fell. In essence, millions of investors, I'm assuming with some degree of intelligence, sold low and bought high. Isn't that the opposite of what investors are supposed to do?

In most economic transactions, lower prices generally lead to more demand. For example, if steak is on special at the grocery store, more shoppers will buy steak than veal roast. If car manufacturers offer zero-percent financing, more cars are sold. This is called getting good value. But, as has been rehashed ad nauseam, investors wanted the most valueless stocks during the Internet bubble, and the higher the price, the lower the value, the more demand increased. By the calculations I documented in "Stock Market Valuations: Too High, Too Low or Just Right?", the S&P 500 peaked at 70% overvalued in March 2000. During the peak selling of equity funds in July 2002, the same calculations showed the S&P 500 to be at least 40% undervalued.

I have a couple of explanations for why this phenomenon occurs, and a couple of strategies to help you get a better handle on buying low and selling high.

Tyranny of the Straight Line

"Since housing prices are up these past five years, they'll be up next year." "If stocks are down over the last 30 months, they'll be down for the rest of the year." The human psyche looks at a series of data points and automatically draws a straight line to eternity. This simplistic model will trip you up, time and time again.

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David Edwards is a portfolio manager and president of Heron Capital Management, a New York management firm. Edwards was a contributor to Harry Domash's Fire Your Stock Analyst: Analyzing Stocks On Your Own available at Amazon. At the time of publication, his firm held no positions in any companies named in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Edwards appreciates your feedback and invites you to send it to David Edwards.