Daily Note: The Paradox of “Buy Low, Sell High”

Tuesday, February 24, 2009

The Paradox of “Buy Low, Sell High”

If everyone could “buy low and sell high” when making investment decisions, everyone would be a successful investor. I would never give this advice to anyone. First, it is obvious to anyone who understands basic arithmetic. If you want to make money, you have to sell something for more than you paid for it. This is why people are reluctant to sell houses right now. Buyers are waiting for lower prices because they think the market will continue to go down for some time and sellers—unless they are highly motivated—don’t want to sell until prices go back up.

Second, it is impossible advice to follow. Unless you have inside information on a specific company—and that is very unlikely—you don’t know with certainty whether a stock price is going to up or down over the next month, year, or decade. The price set by the market, with so many buyers and sellers, is generally the accurate price for that stock at that time. The only way to know whether a price was a “low” or a “high” is to look at the numbers well after the fact.

On Friday, the S&P 500 index hit a low point not seen since the mid 1990s. But will future investors look at Friday’s price as a low? It depends on where the stock market goes from here. Many experts predict that the bottom has not yet arrived. Friday’s low might be high compared to what the future may hold if stocks retreat to levels not seen since the 1980s.

In reality, people don’t buy low and sell high. Yes, there is the argument that people follow trends (rather than lead trends), often resulting in buying high and selling low. But more importantly, investors buy when they have cash and sell when they need cash. As it happens, on average, people have cash when the economy is good and need cash when the economy falls. Stocks are often a victim of this same economy. The stock market generally follows the sentiment of the greater economy, so your cash moves into stocks when they are high and moves out back to cash when stocks are low.

This phenomenon is a result of looking at averages; on an individual level, anything can happen. You could be flush with cash while the rest of the economy suffers and more people are out of work, or you could be struggling while everyone else flourishes. On average, economic conditions force investors to buy high and sell low.

One way to turn this around for your own benefit is to try to understand what most people are doing, and do the opposite. If you buy stocks while there is a general tendency among the rest of the market to panic and sell stocks, you have a better chance of buying at a low point. If investing becomes the latest craze and you can’t go anywhere without having stock tips thrown at you, the exuberance could be irrational and you have a better chance of selling at a high point.

Rather than advising someone to “buy low and sell high,” a strategy which would involve knowledge of the future, perhaps it would make more sense to advise to “buy during panics and sell during exuberance.”

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