The Season for Buying – and Selling

February 23rd, 2010

To everything, there is a season – and a time for every purchase under heaven. No, that‘s not a misprint – just an economist’s reworking of the Biblical passage.

Every recession brings with it a curious phenomenon. Non-professional investors exit the stock market like a herd of lemmings with an appointment at the edge of the cliff. Eventually, the same people stampede into the stock market during the expansion phase of the cycle. Typically, net stock-market inflows peak at or around the apex of the cycle.

This is no way to run a railroad.

The general idea behind portfolio investment is to make money. From a capital-gains standpoint, that means buying when prices are low and selling when they’re high. Buying at the top of the stock market and selling at the trough is the reverse of what we should be doing.

To be sure, we have to make some allowances. Some of the stock sales come because people need cash for various and sundry reasons. Some of the reasons are related to the recession – temporarily replacing income lost to unemployment or pay cuts, financing job search or paying a psychiatrist. The behavior in need of modification is that guided by emotion rather than reason.

Why Do Average People Sell Low?

Many of the sales come because people believe that bad news must breed more bad news. If the stock market plummets, it can only be because the world is ending. Nothing relieves the pain of the end of the world like having lots of cash on hand, so they’d better sell stocks before prices fall to absolute zero.

Have stocks ever fallen to zero? Well, no. Could they? No, not unless they’re penny stocks. What will be the practical result of selling out at the bottom of the market? The sellers will lose money. Lots of money. The beneficiaries of this generosity are mostly financial professionals, who are the ones buying while average people are selling.

Why Do Average People Buy High Instead of Low?

This is the most disastrous of all major investment mistakes and the least excusable. The operative guideline was laid down by the legendary Baron Rothschild, scion of one of the world’s greatest financial dynasties. “The time to buy,” the Baron declared, “is when blood is running in the streets.” For current purposes, we will assume that the blood is figurative, metaphoric blood, although in the Baron’s day it was usually literal; the Baron made a killing from wars, investment-wise. His point was that the best buys are at the lowest prices, and these are to be found when the economic climate is at its darkest and stormiest.

Even people who understand this at a conscious rational level have a hard time living by it. In practice, people want a sign, a portent, some sort of proof or encouragement that they are doing the right thing – that the price of their assets will rise shortly after they buy them. By the time they’re convinced that price increases are not a ruse devised by the malevolent market to trick them into losing their investment, market prices are at or near their peak and the chance to buy at bargain-basement prices has been frittered away.

Who’s Afraid of the Big, Bad Bear?

The ironic thing is that the general public shouldn’t be waiting or praying for the market to recover before investing, at least not as long as they are investing for the long term. Suppose you follow the normal practice of middle-class investors – contributing monthly to an IRA or 401(k) or some other retirement-savings plan. The last thing in the world you should want is for prices to rise. As a purely heuristic exercise, assume you could dictate how the market would go from now until your retirement. What sequence of events would best suit your interests?

The best thing that could possibly happen would be for the market to fall precipitously as soon as you start investing, to the lowest level consistent with normal life – and stay there until the day that you retire. Why would that be good for you? Suppose you’re investing in equities – either individual stocks or mutual funds. This would allow you to buy tons and tons of shares at rock-bottom prices. By retirement, you would own a vault full of stock or fund shares. Then, on your retirement day, it happens – the market zooms up to the sky! You sell all your shares. You are rich. You buy a life annuity and retire in solid comfort, spending the rest of your days indulging yourself.

To be sure, this is an artificial, ideal sequence of events. But the basic point is entirely sound. As long as you’re a regular, diversified investor, a falling market holds no terrors for you – just the opposite. Where investments are concerned, the law of gravity works in reverse – what goes down must go up. Over time, human knowledge, innovation and productivity increase, and this must cause the overall value of production to increase in the long run. This, in turn, causes the stock market to rise in reflection of this increase in production. The value of the shares you bought cheap will rise, making money for you.

What about the poor people who were tantalizingly close to retirement when the rug was pulled out from under the market in the fall of 2008? Well, after age 50, you begin gradually changing the asset allocation in your portfolio, holding more fixed-income assets like bonds, CDs and annuities and fewer equities. When you’re a year or two away from retirement, your portfolio is already weighted toward fixed-income assets, not stocks. You may be hurt by a stock-market collapse, but not destroyed. You simply continue on with your financial plan, retiring as soon as you are willing and able, and make the best of the cards you are dealt.

Why Don’t Average People Sell High?

This is a much more complex, subtle question. The foregoing example of the optimal pattern of stock prices – rock-bottom low while you were buying, then sky high when the day came for you to sell – assumed that you sold out at the peak of the market. In practice, nobody can do this except by luck. Even the Baron himself usually couldn’t spot the top of the market and didn’t really try. You aren’t a financial genius, trying to make large capital gains by making strategic decisions. Your sales should be dictated much more by your stage in the financial life cycle – and by unforeseeable events in your personal life – than by price movements in the market. If you consistently seize opportunities to buy low, you can’t be hurt too badly matter when you sell.

Average investors do seem reluctant to sell at market tops. This reflects a correlative need for reassurance that they will not “miss out” on further price increases by selling too soon, stemming from the complacent assumption that good times will continue indefinitely.

That is not to say that average investors (or their representatives) should be able to foresee the course of future prices well enough to know when to sell. It simply means that investors should follow their financial life-cycle plan, which calls for rebalancing portfolios away from equities and toward fixed-income assets as they age. That will automatically tend to make some sales at advantageous times and reduce the impact of any one bear market on their wealth.

Category: Annuities, Economic Analysis, Economic News, Retirement Planning | Tags: , , , ,

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