Buy a stock when it's cheap. Sell it when it's expensive. Pocket the difference.
Buying low, selling high is such a rudimentary, fundamental investment principal that it sounds like a cliché. But unlike so many well-worn sayings tossed around by financial professionals, this common phrase is a great piece advice that all investors should try to follow.
Many, however, do not.
For some investors, a flawed strategy prevents them from executing. Others are simply responding to misplaced fear. Others still miss the opportunity because they are victims of rampant industry misinformation and conflicting advice.
4 Ways Investors Go Wrong
Every savvy investor knows to buy low and sell high, but some fail to do so for one of four reasons:
- Overinvestment: Some investors have 100 percent of their investable money invested 100 percent of the time. When a stock dips low, they simply don't have enough cash on hand to buy it. This is a basic strategy flaw that can be easily fixed.
- Misinformation: Investors are told as gospel that they cannot and should not try to time the market—that they should buy, hold, ride out slumps and wait for the inevitable rebound. This directly contradicts the common-sense strategy of buy low, sell high. It makes little sense that investors should have to suffer massive losses during investment crashes to participate in the fruits of the markets.
- Fear of selling early: Investors often fail to recognize when a market has reached its peak. They neglect to sell because they are afraid of exiting too early and missing out on the return they would gain if the price continued to rise.
- Underestimation of percent loss: Many industry professionals, including CPAs and bankers, don’t understand the magic of percent loss and its exponential attack on gains.
We know that:
- A loss of 10% needs an 11% gain to recover.
- A loss of 20% needs a 25% gain to recover.
- A loss of 50% needs a 100% gain to recover.
However, investors may not know that, in recent history:
- A loss of 57% requires a gain of 132% to recover.
- A loss of 75% requires a 300% to recover.
- A loss of 80% requires a 400% gain to recover.
- A loss of 89% requires an 809% gain to recover.
The Conflicted Investor Mentality
The third point is the most difficult to correct because it deals with misguided fear. Investors should have a healthy fear — but not of selling for too little profit before a stock peaks. Instead, they should fear losing money if the price drops after they neglected to sell when they had their chance.
The way investors think is often directly at odds with the way they operate. Most investors know they don't want to lose money and are hoping for a good return. In practice, however, many investors take significant risk by holding a stock too long in pursuit of hypothetical gains that aren't based on evidence.
Real World Examples
Recent fluctuations in the price of oil provide a relevant example of this phenomenon. Oil prices began sliding in 2011, but since they quickly rebounded to $132, the market didn't take much notice.
In the fall of 2014, however, prices plummeted to less than $100 a barrel. The price chart by itself gave no indication that something out of the ordinary was under way. Upon adding moving averages, however, the investor gains not just historical perspective, but a warning mechanism revealing an imminent decline.
Take a look at the two charts:
- Notice the white line (price) dips below the blue line (50-day moving average). This is not uncommon.
- Notice the white line and the blue line both dip below the green line (200-day trend). This occurs less frequently.
In discussing an unnecessarily complex color-coded terror-alert system, comedian Ron White mused that there should be only two real warning levels:
- Grab a helmet.
- Put the helmet on.
If that logic were applied to moving averages, the white line and green line dipping below the blue line would signal it was time for investors to grab a helmet (prepare to take evasive action).
When the market moves 20 percent below its recent high price, the chances of a crash increase dramatically. Now would be the time to put the helmet on, which means having an advisor who can take appropriate action. We talk more about that specifically in our Stock Market Crash Management series. As you can see those without that type of advisor, or a buy and hold advisor, may suffer more than necessary, or the brunt of a full 60, 70 or 80% decline.
These scenarios illustrate some of the conflicting advice and misinformation that clutters the industry and dulls an investor's instincts.
Investors know to buy low and sell high, but they are conditioned to hold even when it is not in their best interest to do so. Finding and following markers like moving averages and thresholds below the market may help investors make clear, fact-based decisions. Finding an advisor who does this for clients is now possible for you, now that you know the truth.
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