Buy High, Sell Low: What's the Logic Behind?

When it comes to investing, most of us have heard the classic advice: "Buy low, sell high." It's simple, easy to understand, and seems like a surefire way to make money. But there's another strategy that seems to turn this advice on its head - trend following. At first glance, it might seem strange. Why would anyone want to "buy high, sell low"? Let's dive into the logic behind this approach and why it might make sense.

Understanding Trend Following

Trend following is an investment strategy where traders buy assets that are going up in price and sell them when they start going down. Essentially, they follow the trend of the market. If the market is going up, they buy; if it’s going down, they sell. The idea is to make profits by riding the wave of market movements.

Why Buy High?

Imagine you're surfing. To catch a good wave, you don't paddle out and wait for a small ripple to turn into a giant wave. Instead, you look for a wave that's already forming and ride it. The same principle applies to trend following. When an asset's price is rising, it often continues to rise for a while due to momentum. By buying into a rising trend, trend followers aim to catch the wave and ride it to higher profits.

Why Sell Low?

Selling low might sound counterintuitive, but it's part of the strategy to cut losses and protect your gains. If an asset's price is falling, trend followers (if they are long) sell to avoid further losses. It's like jumping off a sinking ship. By getting out early, you minimize your losses and in order to keep your overall portfolio healthy.

Why It Works

Following Market Trends: Markets often have much larger price moves than most investors can imagine, referred to as “trends” due to investor behaviours, economic news, and other factors. Trend following takes advantage of these movements by going with the flow rather than against it.

Cutting Losses Short: One of the most important principles in trend following is to cut losses before they get too big. If a trend follower buys into a particular market and it starts to drop, they sell it to prevent a small loss from becoming a big one.

Letting Winners Run: Conversely, when an asset is going up, trend followers hold on to it as long as the trend continues. This means they benefit from extended upward movements.

The Psychology Behind Trend Following

Trend following also takes advantage of human psychology. When prices are rising, more people tend to buy, pushing prices even higher. This is called the "herd mentality" and reflects the “FOMO” Fear of Missing Out). Trend followers capitalize on this behaviour by joining the herd early, staying with the trend and aim to get out before the trend has reversed too much from its most recent high or low.

Real-World Example

Let's say you notice that the price of gold has been steadily increasing. A trend follower would see this upward trend and have predefined rules to buy gold, even though its price is higher than it was a few months ago. They continue to hold onto their gold as long as the price keeps going up. If the price starts to drop, indicating a potential trend reversal, they sell their gold to lock in their gains or avoid further losses, should the price go below their entry point.

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