Ask any smart investor and they will tell you that the secret to making money in the market is to buy low and sell high. But how practical is that suggestion from an investor’s point of view. While the buy low sell high strategy appears to be intellectually appealing, the question is whether it is possible to implement such a strategy consistently. What are the risks if you miss out key events and key trades? What does buy low and sell high mean? Does it mean that you have to be right each every time the market moves sharply or do you need to be right majority of the times? Let us finally come to a very realistic question, does buy low sell high work in practice? That is the million dollar question. Let us look at two sides of the argument.
Why buy low and sell high is practically difficult?
While we can be right about the valuations of the market over a longer time frame, it is hard to predict the twists and turns of the market precisely in the short to medium term. That is because, market s are not only driven by past patterns but also by news flows and emerging risks in the market. If buying low and selling high means that you need to get all the twists and turns right then that is being too optimistic.
Any trader has to put a stop loss while trading. That is a barometer of the risk that the trader is willing to take. The extent of stop losses may differ from trader to trader depending on their risk appetite; but stop loss is a must for every trader. The problem with stop losses is that even if your view is correct, the stop loss may be triggered due to the volatility before the hitting the target price.
Trading is not just about your research and your view but it is also about your psychology. Normally, traders tend to panic when markets come down and tend to get greedy at market tops, whereas in reality it should be the other way around. This psychology becomes a big barrier for traders to buy at lower levels and to sell at higher levels.
Liquidity and funds flow also make a difference to your decision. For example at the depths of the market in 2003 or in 2009, there was so much of scepticism that liquidity virtually dried in the market and even your personal liquidity was hit by the sharp correction of 2008. You either did not have the liquidity to buy at lower levels or did not have the access to liquidity to buy at lower levels.
Is buy low and sell high really relevant for traders and investors?
That is perhaps the right question to ask. We spend a lot of time worrying about how to buy low and sell high. Let us look at a more practical scenario of what would have happened to your returns if you had missed the best trading days, if you had missed the worst trading days and if you had just bought the stocks and held on to it? Consider the chart representation below..
The above chart shows how your money would have appreciated in the S&P 500 index in the US markets in three different situations. Remember these charts are on a log scale so the returns are not comparable. It is more to show the relative performance in the 3 situations as is captured under..
As a trader if you had missed the 10 best days in the last 20 years then your returns would have been substantially lower than the index. To be a real buy low / sell high trader you should have been able to catch the 10-best trading days out of over 5000 days of trading and trade accordingly. Even at the outset that looks quite impractical.
While we have not looked at a diversified equity fund, the index buy and hold strategy appears to have worked well considering that it is a low cost strategy. Obviously, trying to identify the best performing days in advance is hardly an easy task.
The only way to beat the market is to miss the 10 worst days in the market out of the last 5000 days. That is more powerful than the index. But that is almost like saying that you are able to predict the market twists and turns to the last decimal. Quite impractical it is, at the very outset!
Is there a more workable approach to buying low and selling high?
While we appreciate that buying low and selling high is not a practically strategy on a regular basis, is there a more meaningful way to apply this through process into our trading and investment process. One way of applying this rule is to use the dynamic P/E based approach to investing in the long run. Here, we are not talking about predicting narrow patterns but about broad patterns. For example, if you take the Nifty P/E or the Sensex P/E as a benchmark and then keep shifting your allocations to equity and debt based on the historical peaks and troughs of the P/E ratio, then you are likely to do much better. Consider the table below which highlights that approach..
The above table is an example of dynamic P/E investing where you keep tweaking your equity and debt ratio based on the market P/E ratio. Over the longer period time you will realize that you have not only beaten the passive index but you will also end up outperforming most of the aggressive trading buy/sell strategies. That could be the key take-away for you from the buy low, sell high debate!