Monday, May 28, 2012

Recognizing When Investing Advice Amounts to Buy High and Sell Low

Almost everyone knows that the path to profits with stocks is to buy them at a low price and sell them at a higher price. Strangely enough, some smart-sounding advice amounts to the opposite strategy: buy high and sell low.

In his book Retirement’s Harsh New Realities, Gordon Pape says
“Moving some assets from an equity fund to a money market or bond fund during [periods when stock markets are going through a rough time] is only prudent.”
This sounds smart until you break it down. “Stock markets going through a rough time” means that stock prices have dropped sharply in the recent past. “Moving some assets from an equity fund” means selling stocks. So, we can translate this advice into “Selling stocks after their prices have dropped sharply is only prudent.” So, we are told to sell stocks when their prices are low.

Some may argue that a “rough period” refers to the near future of stock prices and the advice is actually to sell before prices drop. However, we don’t know when the stock market will drop. When the typical person speaks of a rough period for stocks, it is after prices have dropped, not before. We tend to assume that the near future will be an extrapolation of the recent past, but this doesn’t work for stocks.

At a later point in the book, Pape says
“The minimum allocation [to stocks] should be 20 percent, and you would be at that level only during full-blown bear markets or if you are approaching, or past, retirement.”
Once again, we have to break this down. “Full-blown bear markets” means when stock prices have dropped sharply. The fact that investors are pessimistic about the near future has little bearing on what will actually happen. Getting to the “minimum allocation” means selling stocks. Again, the advice amounts to “sell low.”

Typical investors would do well to admit to themselves that they have no idea what will happen to stock prices in the near term and that they still won’t know after listening to several “experts” with conflicting predictions. Then they will be able to see that some smart-sounding advice actually amounts to buy high and sell low, which is the opposite of what they really want.

7 comments:

  1. Good point. While I am sure Mr. Pape provides some decent advice at times, he should be taken with a significant grain of salt.

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  2. I take advice from Mr. Pape with a grain of salt. This is the guy that peddles those wealth destroying reverse income mortgages to seniors.

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  3. This advice is typical of the author in question.

    From a previous articles: "As a general rule (and there will be exceptions) wait until the indexes have rebounded by 15%-20% before you move [back into the stock market]."
    http://www.gurufocus.com/news/141337/decision-time-what-kind-of-investor-are-you-

    Yes, it is definitely better to wait until prices are 20% higher before you buy. Woe to the long-term inbvestor with this kind of mindset.

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  4. I lost all faith in Gordon Pape when he began pushing the line that he was unconvinced that investing in ETFs was the best strategy for most investors and that he continued to recommend well-run out-performing Mutual Funds. This despite all evidence out there that ETFs will invariably outperform Mutual Funds in the medium to long term.

    In fact, now that I think about it, investing in well-run Mutual funds (as Pape recommends) is akin to this latest recommendation of his. Isn't investing in a well-run out-performing Mutual Fund just the same as buying at the top of the market (i.e. AFTER this well-run Mutual Fund has been briefly out-performing)? Research shows that Mutual Funds that have out-performed for a period will generally under-perform in the following periods. Buy an out-performing Mutual Fund and you'll like find that going forward it will significantly under-perform.

    Best advice to investors is to just ignore Gordon Pape.

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  5. @Anonymous and @Chris: It seems that you have to be knowledgeable enough about finances to distinguish the good advice from the bad.

    @Dan: That quote completes the "buy high" part; I had mainly focused on the "sell low" advice.

    @MarkH: I agree with you that a disciplined buy-and-hold strategy with a basket of inexpense broad-market ETFs with beat expensive active mutual funds over the long term. However, I can understand people who prefer TD's e-Series mutual funds becuase they are more comfortable with mutual funds than ETFs.

    You're exactly right about the problem with buying funds that have performed well recently. Pape didn't even both to address research saying that performance-chasing in mutual funds lowers returns.

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  6. I've seen this kind of advice from many investment types. The problem I have with this sort of thing is that it seems like there is no real investing strategy.

    I have more faith in someone with a momentum strategy (where you typically have to wait for a stock to go up before buying or go down before selling) who has an actual plan with metrics and specific actions tied to specific movements in the stock that they follow. And of course they still need to measure performance against an index.

    Of course, I think momentum investing is hogwash, but at least a solid, definable and actionable plan is better than a vague "sell when things aren't going so well" kind of nonsense.

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  7. @Mike: Your comment reminds me of the Wolfgang Pauli quote “This paper is so bad it is not even wrong.” You prefer a specific momentum strategy that can prove to be profitable or unprofitable to something vague that isn't even wrong.

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