Buying Low and Selling High

The cliche “buy low and sell high” has been around seemingly since the beginning of time.  However, there is quite a bit of depth behind this simple piece of wisdom.  In order to discover this depth, we need to ask ourselves what kind of person will buy low and what kind of person sells high.  We also need to ask what situations result in low prices for you to buy, and what situations result in high prices for you to sell.

Buy Low

Let’s start with buying low.  Simple logic dictates that if prices are low, then there is an excess of sellers relative to buyers.  Thus, buying when prices are low requires us to go against the “conventional wisdom” and make a buy decision when the overwhelming majority of people are trying to sell off their investments.  This is complicated by the fact that it is not possible to predict when any “down market” is going to end.  Thus, any decision to “buy low” carries the risk that prices will continue going down.

In most cases, general sentiment assumes that the current market situation will continue indefinitely.  When prices are going up, people assume that they will always go up.  When prices are falling, people assume that the collapse will never end.  It is almost certain that when you buy against the grain of market sentiment means that your decisions will appear foolish to many people.  After all, the easiest thing to do is follow the crowd.  There is comfort in conformity.  When your friends are talking about buying gold, it’s comforting to talk about how you’re buying gold.  When you hear people talking about getting out of real estate, it’s comforting to share your stories of woe.  Common experiences form a common bond.  Unfortunately, buying low means that you will not experience this common bond, by nature of your moving against the tide of market sentiment.

Sell High

Similar to buying low, selling when prices are high requires us to take a counter-intuitive action.  It requires that we sell off a hot investment in the midst of prices going up, up, up.  While everybody else is trying to get into the game, you will need to be consciously stepping off the train.  There is also the ever-present risk that prices will continue going up after you sell, thus leaving a whole bunch of profits out of your reach.  It requires suppressing the ‘greed’ impulse with ‘sanity’ action.  All people know that trees don’t grow the sky.  Prices don’t inflate indefinitely … market corrections happen.  Prices go up, become over-valued, go down, become under-valued, then go back up again and the cycle repeats itself.

One way that investors can systematically engage in strategic buying and selling is through regular portfolio re-balancing.  By keeping your investment portfolio allocated in a specific, pre-determined manner and regularly changing your investment allocation back to that pre-selected configuration, it will help to avoid becoming over-exposed to market cycles.  For example, let’s assume that you have a portfolio that’s 50% stock and 50% bonds.  The stock half goes up 20% and the bond half goes up 2%.  Now the stock ‘half’ of your portfolio is actually 54% and the bond ‘half’ is 46%.  If you rebalance, you will systematically sell the stocks while they are high and buy the bonds while they are (relatively) low.  Now let’s say that stocks go down 20% and bonds only return 1%.  If you had re-balanced, your portfolio would show a 0.5% gain … if you had not, you would show a 0.5% loss.

So What’s the Secret?

It’s hard to say that there’s a single “secret” per se, but it’s a safe bet that if you’re hearing about a great investment on CNBC, then it is over-valued and you should think about selling to limit your exposure.  When you hear about problem investments like people losing their homes to foreclosure, it could mean that a buying opportunity has emerged from the uncertainty and fear about future property prices.

In the final analysis, buying low & selling high will require a lot of courage and discipline since both actions require consciously moving contrary to the rest of the market and most or all of your friends.  Needless to say, it is something that most casual investors will not be willing to do.  Conversely, if we want to be the people that buy low and sell high, we need to develop the discipline to swim against the tide and live without the comfort of following the rest of the market.