First rule of investing - buy low; sell high.
Everyone understands this rule, but few actually follow it. In fact, most investors tend to do the opposite, selling low and buying high. Why does it prove so difficult for investors to follow this rule?
Canadian adviser and author Carl Richards describes the difference between average investment performance and the average investor's performance, as the "behaviour gap". The difference is due to investor's tendency to buy and sell at the wrong times, instead of simply holding their investments.
The reasons for this gap are perfectly reasonable. Overcoming this behaviour means addressing core human biases and often making investment decisions that seem to go against common sense.
A few things to note when talking about buying low.
Seeing Trends
One of the many advantages humans have over animals is our ability to identify patterns. Pattern recognition helped our ancestors to remember important locations, spot predators and find resources. It also led to the development of language and our appreciation of music.
Bobby McFerrin demonstrates the power of the pentatonic scale, using audience participation, at the event "Notes & Neurons: In Search of the Common Chorus".
The term apophenia describes our tendency to see patterns where none exist. It is why we see figures in clouds or the man on the moon. It also extends to the logic in conspiracy theories and some odd rituals in our daily routines.
If you tap the top of a beer can before opening it, you are a victim of apophenia. The only reason this stops the beer fizzing is you end up waiting longer before opening it. It becomes a ritual as we falsely attribute the lack of fizzing to the tapping.
When it comes to investing, Random walk theory postulates share price movements are random or driven by unforeseen events. This essentially makes short-term predictions impossible.
But if we see a graph showing share prices going up, we quickly assume they will continue going up, and vice versa. This makes it difficult to buy shares when your instincts are telling you to wait.
The News Will Look Bad
While share markets are falling, the news being released will be overwhelmingly negative. Even when the market has bottomed out, the articles you read will still be about things going wrong. Even professional investment managers will be focusing on whatever key figures that, to them at least, indicate a continued slide or imminent recovery.
Over the last quarter of 2018, share markets fell by a considerable margin. This preceded a year where stock markets gained around 20%. NZ Herald's Liam Dann is an excellent business reporter, but his article from December 2018 has not aged well.
“The bull market is dead.
As fresh falls this morning take the NZX-50’s returns for 2018 below four per cent, it’s time to recognise the decade-long equity boom we’ve enjoyed is over.
For the foreseeable future we can no longer expect to see double-digit returns on our KiwiSaver funds.”
The NZX 50 index, representing the NZ share market, hit the bottom the same week this article was published. Over the next quarter, it hit record highs again. Over 2019 it gained more than 30%.
How about CNBC's article titled S&P 500 teeters on edge of a ‘death cross,’ and one key level could determine its next move. What exactly a 'death cross' is doesn't really matter, but it sure sounds scary. Especially when commentators are suggesting certain doom. From Nathan Edwards of IMG Wealth Management:
“The bad news is that there has not been a single bear market in history that was not preceded by, or followed in short order by this indicator.”
In the US, the recovery was also sharp, with the S&P 500 jumping up more than 10% in January. Over 2019 it gained more than 25%.
In the UK, here is the headline for their rolling coverage, last updated at the market bottom, December 19 2018.
Nothing here to be optimistic about! But over the next quarter, the UK share market gained about 8%, modest compared to other countries, yet still a strong recovery.
Here are a few headlines from February and March in 2009, the end of a long share market decline from the GFC:
Forbes - How Low Can the Stock Markets Go?
New York Times - Dow Industrials Plunge to a 6-Year Low
From here, the S&P 500 would gain more than 50% by the end of the year, and 150% over the next five years.
This makes it tough for investors to buy low. As share markets are going down, you will seldom hear anything positive about the market or economy. To buy at these times seems to go against common sense. So instead it is tempting to sit on the sidelines until things "settle down".
But once things have settled down (if they ever are truly settled down), prices are up again. After all, the factors which drove them down in the first place are what made buying so unappealing in the first place.
The problem is, even for experienced investors, we often mistakenly assume the stock market follows the economy, instead of vice versa. By the time things have seemed to have improved, share prices have long since recovered.
Loss Aversion
You can't talk investor behaviour without mentioning loss aversion. Put simply, losing something feels about twice as bad as gaining something feels good. Losing $5 is a bigger deal than finding $5.
If you are already invested, a drop in value hurts. Putting more capital in the firing line is a tough ask, especially when you expect trends to continue.
If you aren't invested, the fear of regret is stronger than the fear of missing out. So we don't feel as bad watching a potential investment going up $1,000 from the sidelines as when we watch it go down $1,000 while invested. The decision with less expected regret is to not invest.
Assuming we invest to reach our long-term goals, the two scenarios are the same, only our perspective differs. It seems we are more comfortable than we should be watching markets soar without us. By the time we are ready to dip our toes in, the low prices have gone.
With the benefit of hindsight, the most common investor regret is not investing sooner. A recent survey by personal finance site MagnifyMoney, found about three quarters of the 836 participants regretted waiting to invest in stocks.
Buy Low Doesn't Mean at the Bottom
The problem with waiting for 'the bottom' before buying is we don't know when we get there. There is no bell at the bottom. Often this will be the time you feel least like jumping in. You have watched the stock market go down and expect the trend to continue. The news is talking about everything going wrong.
The level 4 lock-down was announced on March 23. At the time, we didn't know what this would mean for NZ businesses, employment, the economy. It would be understandable to say "I might wait until we know what's going on", or something similar, instead of investing.
March 23 was also the bottom for the NZ stock market, with the last 8 days of March bringing a 15% total gain. This was during a period of huge uncertainty. People were still hoarding toilet paper at this point. Very few would have picked this day as the best time to invest.
Following the GFC, unemployment in the US peaked at 10% in October 2009 while the share market hit the bottom in March. The share market had gained nearly 50% by the time unemployment peaked.
You don't have to call the bottom to get a good deal. If prices drop, you get a discount. If they drop again, you can buy even more shares for the same amount of money. It will hurt to see your previous investment go down in value, but we didn't know that beforehand. What we do know is the discount on shares is even better now.
Ben Carlson explains what buying low really means in his March 1 article:
“Buying stocks when they’re rising is easier because every purchase makes you feel like an investing genius. Buying stocks when they’re falling is harder because almost every purchase makes you feel like an investing fool.
Buying stocks when they’re seriously falling, as they are now, rarely feels like the right move.
Every investor is told to buy low and sell high. But most don’t realize that buy low typically works out to buy low, then buy lower, then buy even lower, and once you really hate yourself, buy lower than you thought was possible.”
How to Consistently Buy Low
So some of the reasons why it is difficult for investors to buy low:
We expect downwards trends to continue.
All the negative press seems to support this view.
We feel more comfortable missing out on gains than suffering losses.
We can't time the bottom, and buying as prices fall feels terrible.
All these factors lead investors to wait until prices are high. At this point, we expect markets to continue upwards (more often true than not, to be fair) amidst positive press. With the worst times in the rear-view mirror, the fear of losses is replaced by a fear of missing out.
To avoid these mistakes and benefit from low prices, you need a strategy and discipline.
For those already fully invested, without spare income (or cash) to invest, buying low is a part of rebalancing. When some of your investments do well, such as shares, a strict rebalancing policy means selling these investments to purchase those that have not. Doing so ensures you are regularly buying low and selling high in a disciplined manner. This also ensures the risks you take are consistent over time.
If you are still saving, set up an automatic deposit to invest weekly or monthly. Do not change your savings rate based on what is happening in markets and the news. This ensures you will be purchasing throughout volatile times, and the highs and lows will average out. Remember, it is time in the market, not timing the market that generates returns.
And if you are confident enough to act against your biases in favour of really buying low, consider some of the following additions to your financial plan:
If the market drops by X%, I will increase my contributions to $X (or reduce withdrawals to $X).
If my portfolio value drops in value over the quarter, I will deposit the amount by which it dropped into the portfolio.
If my portfolio value is below what I expected it to be in a given quarter, I will deposit enough to bring my portfolio back to target.
Most importantly, whichever strategy works for you, stick with it. We can't control markets but we can control our decisions. Overcoming your bias and fears of regret now means greater outcomes and less regret in the future.