This is part five of a series on market psychology, specifically about the concept of buy low, sell high. Click here for part one on decoding market psychology. Click here for part two on investor sentiment and fundamentals. Click here for part three on emotional investing. Click here for part four on the herd mentality.
Perhaps one of the oldest adages about investing that’s still repeated today is this: “Buy low; sell high.” In theory, that makes a lot of sense. Why would you want to buy an asset after its price increased and sell it when its price has declined a lot? And yet, that’s exactly what many investors do, and they only have their emotions to blame.
Buying at the bottom is great… in theory
It’s pretty obvious why you would want to buy an asset when it’s at a recent low, but buying at the bottom is much easier said than done. The issue is that you can never really know when a stock or other asset has hit bottom until you’re past the bottom, and it’s back on the rise again. Additionally, not all rallies are lasting, so while there could be a temporary bounce, there is always a chance that an asset’s price will end up in freefall again before a strong rally finally carries it out of the doldrums.
Trying to buy at the top presents the same problem as buying at the bottom. You can never really know if an asset has reached a top until after it has started to fall. The best you can do is make educated guesses about where prices will go next based on what’s happening in the market and economy. Unfortunately, studies show that oftentimes, those educated guesses turn out to be wrong. Even professional traders and fund managers make these types of mistakes, so the best course of action is to make plans and stick with them, no matter what the market is doing.
Timing the market generally doesn’t work
For example, a study published by Boston College’s Center for Retirement Research in 2017 looked at target-date funds. The study examined the performance differences between those that veered away from their original strategy in an attempt to time the markets and those that didn’t. Target-date funds are designed to automatically adjust their portfolio allocations as their target date approaches. For example, funds with a target date in 2025 will gradually get more and more conservative as the year approaches.
Researchers found an underperformance of 14.1 basis points in funds that deviated from their counterparts that didn’t deviate. That isn’t very much, but it does add up to about 4% over 30 years. Another study conducted by Dalbar in 2016 found that equity mutual fund investors saw a decline of 2.3% in 2015 even though the S&P 500 gained 1.38% during the year. Over 20 years, the performance gap between the average equity mutual fund investor and the S&P 500 grew even bigger, to an annualized return of 4.67% compared to the S&P’s 8.19% return.
Here’s why it’s so hard to buy low and sell high
Aside from the simple problem of not being able to guess the market’s top and bottom, there are other reasons the “buy low, sell high” philosophy doesn’t work well in practice. However, if you understand why you do what you do, it’s easy to avoid such practices. The problem tends to occur when investors fall victim to one or more biases.
For example, some investors embark on research with a theory and then work backwards to try to prove their theory. Doing this can make it easy to accept all the evidence that backs up your view and ignore any articles or commentary which goes against it. A better way is to look for evidence that disproves your theory. If you’re actively looking for commentary that goes against what you think, then you will be setting your emotions aside by allowing the contrarian view to inform your decisions.
Another bias that interrupts the “buy low, sell high” philosophy involves thinking that the current situation will never end. The current bull market has been going on for so long that many investors have been lulled into thinking it might not end. However, the longer this bull market gets, the closer we are to its end. This is exactly why some hedge fund managers have begun repositioning their funds with a more cautious view. Everything ends at some point. The only question is when.
There are many more potential biases to fall victim too. The best course of action is to ask yourself why you feel convicted about a certain position you hold and consider the opposite viewpoint, looking for any biases impacting your conviction in the process.
The best alternative to buy low, sell high
So if the strategy of buy low, sell high is just a pipe dream, what should investors be doing to maximize their portfolio returns? Index funds and target-date funds are excellent vehicles to invest in because they protect you from these investor biases. Index funds track major indices like the S&P 500 or NASDAQ Composite. Target-date funds that don’t try to time the market force your portfolio into allocations that make sense for where you are on your path toward your goal, whether that’s retirement, buying a house or something else.
The key is to think about your investments with a long-term mindset rather than getting swept away by short-termism. By remaining invested, you give your portfolio time to recover from serious downturns. In a best-case scenario, avoiding the 40 worst trading days can boost your portfolio returns 952%, according to data collected by Index Fund Advisors, which was sourced from Yahoo! Finance between 1998 and 2017. However, entering and exiting the market with a short-term mindset sets you up to miss the 40 best days, which resulted in a 114% loss during those years.
Why buy and hold remains the best strategy
It’s important to remember that these are worst-case and best-case scenarios, so the average investor’s portfolio is going to be a mix of the best and worst trading days, whether they trade in and out of the market or not. Dimensional Fund Advisors looked at short- and long-term investors with a mix of 60% stocks from the S&P 500 Index and 40% U.S. Treasuries. A static portfolio and one with random timing saw the same monthly average return, although volatility in the randomly timed one was higher. Volatility often results in more stress for investors, but despite the extra stress involved, the end returns were the same. Looking out over the decades from 1926 to 2016, the static portfolio posted an annualized return of 7.78%, outperforming the timed portfolio’s return of 7.35%.
These studies suggest that investors who try to time the market tend to underperform it. What makes timing even worse is that in addition to possibly missing out on the best trading days, you’re also racking up transaction fees. The more often you trade, the more you pay in fees, so that decreases your return even further.
On the other hand, a buy-and-hold strategy keeps you invested and enables your portfolio to recover from downturns. This doesn’t mean you keep holding onto a loser when it becomes obvious that the position will not recover, but it does mean keeping an adequately diversified portfolio will help you ride out difficult times when volatility strikes some asset classes and drives others up.