On Buying Low and Selling High

Let’s say you are starting a business.

An unexpected opportunity is granted to you on day one, and you are given the ability, prior to investing a cent, to choose one of two business strategies. You may either:

A: Buy high, sell low

Or

B: Buy low, sell high.

Which would you choose?

The answer is obvious. You would take option B. This is clearly a better way to make a profit.

When it comes to investing, you’re faced with a similar choice.

There is an opportunity to repeatedly buy low and sell high. It is called rebalancing.

If at fixed intervals of time we sell the over-performing assets in our portfolio, and buy more of the underperforming assets, we accomplish two important objectives.

First, we keep the risk profile of our portfolio in balance.

If our risk tolerance means that we elect to hold a portfolio that is 60% stocks, and 40% bonds, then this is what we should strive to maintain.

But if stocks grow at a pace that is more rapid than bond growth, then over time the percentage of stocks in our portfolio will increase. This means that our portfolio will morph into a more risky portfolio than the one that we originally intended to own.

In addition, when we sell asset classes that have recently grown and buy asset classes that have recently underperformed, we’re essentially buying low (undervalued assets) and selling high(overvalued assets). We’re locking in the profit that we have already made.

The unfortunate fact is this. We’re not going to want to do it. It is not (behaviorally) easy at all.

Imagine this: it is January 1st and you buy one thousand dollars of McDonald’s stock, and a thousand dollars of Sony stock.

Each day you check the two stocks.

You’re excited every time you look at the McDonald’s stock. It seems to grow every day. By March 1st, your $1000 investment in McDonald’s has matured into $1237. This makes you happy.

Furthermore, every time you turn on the business news, (ex. CNBC) some analyst is singing the praises of McDonald’s CEO and his surefire plan for growth.

Unfortunately your Sony stock is not doing so well. It has more days of losses than days of gains and on March 1, it is only worth 894$.

Those same CNBC hosts give consistent and helpful insight into the dismal future for television sales, and the poor economic environment for Japanese companies as a whole.

What are you going to want to do on March 2? Will you want to sell McDonald’s in order to buy more of Sony? Or will you want to sell Sony and buy more McDonald’s.

I would argue that you will want to sell the Sony and by the McDonald’s. Which is the wrong thing to do.

We all want to win. We invest to make money. So it is only natural that we will have an affinity for those classes within our portfolio that are currently performing well. Likewise, the recent poor performers will seem like bad bets. We will want to get rid of them because every time we look at them we get negative feedback. (We lose money.)

This natural instinct is why people tend to do things like sell all their stocks at the bottom of a bear market (Think of the financial crisis of 2008.) Their loss of wealth makes them feel terrible and they want to get rid of the risky assets before more dreaded losses accrue.

Unfortunately when they do this they are locking in their losses. And they’re locking themselves out of the (almost) inevitable rebound of the stock market over time.

Similarly, we all naturally want to get into the stock market when it is growing. We see opportunity. There’s money to be made….This time it’s different.

“I want you to tie me to a mast and stick wax in your ears, okay?”

Which is why smart investors like Warren Buffett advise us that we should be fearful when everyone is greedy, and greedy when everyone is fearful.

Rebalancing means doing the right thing even though it is opposite of what we want to do.

We are like Odysseus tying himself to the mast of his ship before he sails by the Sirens. We know beforehand, that the siren song of profits will make us want to crash our ship into the rocks, so we make an agreement with ourselves to rebalance our portfolio every three months no matter how bad it feels.

It’s eating our vegetables. It’s brushing our teeth. It’s getting enough sleep. We know before hand that we won’t want to do it but we also know that it’s the right thing to do.