In order to get through life without making ourselves crazy, we often apply a ‘rule of thumb’ to dealing with the every day. If the person in the lane driving next to you isn’t weaving all over the place we assume that he’s a good driver and trust him to stay in his lane. This rule of thumb concept is called a heuristic. We use many heuristics to allow us to simplify the complexities of life.
But sometimes we take our heuristic and misapply it. For example, our experience is that generally light objects fall more slowly than heavy ones. What our heuristic is about in this case is not weight but air pressure. A feather falls more slowly than a golf ball because of air pressure. But our heuristic leads us to think a bowling ball will fall faster than a golf ball because it is heavier. In reality a bowling ball will fall at the same rate (roughly), as air pressure doesn’t make a significant difference. Here we are misapplying our heuristic.
Where am I going with all this? Well it’s with another law of physics, momentum. Momentum tells us that a bowling ball that’s moving will keep moving in the same direction. We now have a heuristic that lets us go bowling. But many people misapply this heuristic to the stock market. There is a widespread belief by many investors that a stock that is going up will keep going up and one that is going down will keep going down. If someone buys a stock because it went up, or sells one because it went down, they are misapplying the concept of momentum to stocks.
Unfortunately, stocks have a tendency to turn on a dime, not something a bowling ball does very often. This may be because of an earnings report or a new product introduction or a thousand other factors. There are useful heuristics in investing. Buy low, sell high comes to mind. But momentum just doesn’t work in the stock market, however much it may help in the bowling alley.