When You Trade and Invest, Why Use the Wave Principle?

By Elliott Wave International

The question: Why use the Wave Principle when trading or investing?

The answer: To avoid the herd that usually loses money in the markets.

The explanation: Herding makes it difficult to follow the most useful trading advice to buy low and sell high. More often than not, what really happens is that you hear about a stock or an index and decide to buy it because it’s in the news. Why is it in the news? Usually because the price has been going higher. Lots of people in the financial media say that it’s doing well, so you decide to “get in now” — even though you know the shares are not at a low. After all, why would people talk up the stock if it were headed down? And you wouldn’t really want to buy a stock other people were selling … would you?

Once you buy, one of these three things usually happens:

1. The stock or index continues up for a brief time. You manage to hold on until just after it turns down, and sell so that you get out near the top. (You didn’t buy low, but you sold it for more than you paid and made some money.)
2. It goes up and then down, and then up and down again — and again — while you agonize. You read whatever you can find to help decide whether to stay in or get out. You finally get out about where you got in. (You neither bought low nor sold high, nor did you make any money.)
3. It turns down after you purchase it. And it keeps drifting down until you can’t stand it anymore. So you sell. (You bought high and sold low; depending on how long you held it, you lost a little or a lot of money.)

The outcome: Either you win small, you come out even (except for brokerage fees), or you lose either big or small. What happened to the simple and elegant idea of buying low and selling high? Well, that idea vanished in the labyrinth of your quickly turning, emotional mind. When it comes to real-time decisions, it seems nearly impossible to do what you know you should to do to make the most money. The irrational mind beats out the rational mind. Welcome to the world of herding.

Elliott Wave International’s educational guru, Wayne Gorman, explains it this way in the Elliott Wave Crash Course:

“The process is being driven by an emotional, unconscious response by investors who look at the market subjectively and impulsively and who must make decisions under conditions of ignorance and uncertainty.… Most people tend to engage in what we call herding. They follow the actions of others, whether those others are on the right side of the market or not.

“The result is that prices move up and down according to investors’ optimism and pessimism. Investors use the news to rationalize their emotional decisions, and most people lose money.”

Even the big boys do it. Stock mutual funds tout their investing know-how, yet this chart shows that they also succumb to buying at tops when prices are high and selling at lows. It compares 40 years of the S&P 500’s price moves with the changes in stock mutual funds’ cash vs. assets ratio. When the percentage of cash is low, it means that the funds are buying stocks and keeping less cash (marked as “Bought” on the chart). When the percentage of cash is high, they are selling stocks and converting to cash (marked as “Sold” on the chart).

Gorman again: “Notice that funds are heavily invested in stocks at top of markets and little invested in stocks at major bottom. This pattern tends to repeat itself over time — and results in losses.”

The better way to do it: The Wave Principle, on the other hand, provides rules and guidelines to help you avoid the herd of investors, particularly as they react to the latest news. You can see patterns in price charts and decide when a market may be about to turn up or down; you can also plan when to trade or invest with some objectivity.