In the last MarketPulse we commenced a discussion on the importance of following the trend in our investing and trading. We noted that in many cases whilst we know that the trend is our friend, too many investors choose to fight the trend. These investors were more focussed on value and tended as a result to buy securities when the price was low, and sell securities when the price was high. They did this in the general belief that low prices represented good value, or that a security was ‘cheap’, and that high prices represented poor value, or that a security was ‘expensive’.
Technical analysts do not study the value of securities but rather their price. ‘Trend followers’, who are a subset of technical analysts, choose to invest in the exact opposite fashion to value investors preferring to invest their capital when prices are high, and to sell or short sell when prices are low. This is an outcome of an understanding that when prices are high, it is likely that they became so as a result of an uptrend. Conversely, when prices were low, it is likely that they became so as a result of a down trend. Trend following technical analysts concede that they’ll never really know if a security is ‘cheap’ or ‘expensive’, simply that by buying high and selling low, they are more likely to be following the trend and therefore give themselves the greatest probability of success.
This week we want to delve deeper into why it is so hard for many investors to shake their obsession with the concept of “buy low, sell high”. We want to prove beyond all reasonable doubt that it is a far more robust and profitable strategy to buy when prices are high and to sell or sell short when prices are low. We want to dispel the myth that value investing is a safe, sound, and effective strategy for the average investor. Following on from this we will prove that a trend following approach is the best way for both novice and professional investors to achieve long lasting success in the markets.
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Cheap skates never prosper in the markets
We are taught from a very young age that buying when prices are low is a good strategy. One might remember following our mothers through the supermarket as a child and noting her stock up on specials. “Bananas are cheap this week sweetie. Last week they were $2.99 a kilo and this week they are on special at $0.99 per kilo. We better stock up on bananas; who knows how long this special will last!?”
As we grow older this strategy of buy low is further reinforced. Think about this for a second: if you could help it, would you fill your car with petrol on a Friday? No. Why? Because you know that with lots of motorists filling up before the weekend prices tend to be the highest on Friday. We all know that there is a ‘petrol price cycle’ where prices rise towards the end of the week but tend to be cheapest in the middle of the week. We’d prefer to fill up when prices are low and avoid filling up when prices are high.
In each of the cases above, it doesn’t make sense to pay more than you have to for a product or service. It also makes sense to capitalise on low prices and to stock up before prices return to normal. If prices are high, then it makes equal sense to wait for them to come down again before purchasing.
This obsession with trying to buy low, and avoid buying high is the second greatest contributor to novice investors consistently losing money in the markets. The greatest contributor is holding onto losing trades for too long. We have discussed this concept at length in previous MarketPulse articles and I refer you to the archives for more information on that topic.
The market goes up in the long run is only half the story
The ‘buy low, avoid high’ strategy simply does not work in the long run for the share market (or any other organised financial market for that matter either). Many investors confuse the old adage of “the market always goes up in the long run” as a directive for buying low. The theory is that one can simply buy stocks after a correction and wait for them to return to their pre-correction levels.
Whilst mathematically it may well be true that stock markets go up in the long run, there are a number of reasons why using this as a justification of the buy low strategy is a flawed argument. Firstly, it would be more accurate to say that “stock markets always go up and down in the long run”. We know that all bull markets are followed by bear markets. Whilst bull markets tend to push prices higher for longer, only foolhardy investors do not fear the severity of a bear market.
Secondly, due to a phenomenon called ‘survivorship bias’, the long run upward curve of the market is exaggerated. Survivorship bias refers to the common practice of dropping underperforming stocks out of a benchmark index. As those poorly run companies go down the gurgler, they are stripped from the index and better performing stocks are added. This tends to skew the performance of the index to the positive as the old dogs are discarded and forgotten.
The best way to illustrate how much survivorship bias can unduly inflate a benchmark index is to consider how well the top one hundred stocks listed in Australia in 1910 are performing now! Whilst I am the first to admit that I haven’t done this research, it is fairly safe to say that none of them are still listed on the market today. So whilst it is fair to say that ‘the market’ goes up in the long run, it is not fair to say that any particular investor’s portfolio will go up in the long run. This will depend solely on the investor’s ability to select and maintain a portfolio of outperforming stocks.
Finally, one must consider the time it takes to move between market peaks. By this I mean regaining a bear market’s entire decline. This is something which I have done some research on. For the last 30 years, it has taken an average of 7.5 years for the ASX All Ordinaries to regain its bear market declines when adjusted for inflation. There is no doubt that every time there was a severe correction in prices the market eventually bounced back. Those who held on to stocks lucky enough to survive the crisis generally made even greater gains. The question is: How many investors can afford to wait 7.5 years to simply break even?
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What if this horrible scenario (a major market correction) befell you in your first year of retirement? 7.5 years of subdued returns and nervousness would be excruciating and debilitating to your planned retirement lifestyle. Don’t think you’ll be that unlucky? Well tens of thousands of investors generally of the ‘baby boomer’ generation took advantage of the Howard Government’s generous concessions for superannuation in June 2007. The top of the market prior to the recent GFC was in November 2007. Many were sitting on losses of over 50% within just a year, and here we are over 3 years on from the start of the correction, and we aren’t even half way back to breaking even…
We cannot always trust the market, and more importantly, the stocks in our portfolio to ‘go back up’. Buying when the market appeared to be low at the start of 2008 only lead to disaster, and almost certainly, if this buying was concentrated in those stocks beaten down the most and which looked ‘too cheap’. Stocks like Babcock and Brown, Allco Finance Group, Centro Properties, and ABC Learning Centres are all good examples of stocks which will never ‘go up in the long run’ with the rest of the market. They are (with the exception of Centro which remains but is down some 99% from its highs) all bankrupt and delisted from the exchange.
Buy cheap bananas, avoid “cheap” stocks
Once again, the market does not reward flawed logic like, ‘but it will go back up’. The market rewards good stock selection and good trading practice in identifying when to purchase those stocks. Good trading practice involves following the trend and this thankfully prohibits us from buying depressed stocks. On the contrary, it often means that we are buying at the highs and riding the new bull phase.
In conclusion, shares in companies are not bananas. They don’t get put on special and therefore become cheap. When bananas are on special, there is generally a strong chance that their price will indeed increase again in the future. There will always be a demand for bananas (they’re delicious and nutritious and make a great on the go snack!) This is not necessarily the case for shares. They have no other physical purpose outside of potentially providing a financial return. Therefore one could very easily find themselves in a situation where the shares aren’t worth the paper their CHESS statements are printed on.
Buy bananas when they’re on special – by all means. When it comes to shares, do what professional traders do and follow the trend. Shares which have fallen in price need to be avoided at all costs. This does not mean that investors can never buy shares which are recovering, simply that the astute trader will wait for clear-cut signs that the price is recovering. That is, that a well defined and strong new uptrend has emerged.
We’ll conclude this discussion on trend trading in next week’s MarketPulse article.