Do a Premortem to Avoid the ‘Buy High – Sell Low’ Problem
We’ve all heard the old adage:
Buy low – sell high
But how many investors actually follow this ‘best investing practice’?
Are you guilty of this big investing mistake?
Turns out, there are reams of data about how investors consistently make this big investing mistake; buy high and sell low. You’ll learn about how this happens, and how to counteract this losing investing strategy.
Over decades of investing, I’ve seen this investing mistake replayed over and over again. Specifically, the market dives-investors panic and sell. Then, the market rebounds, but investors are still scared by the prior drop so they wait to buy back in. After a major price advance, investors gain their courage, and reinvest in the markets – only to watch a cyclical market decline soon after they got back into the market.
Have you make this big investing mistake?
Notice this chart of SPY ETF, a proxy for the S&P 500. From August 1995 through mid-August, 2015, there have been several market dives and peaks. There’s nothing unusual about this pattern. You’ll find normal economic and stock market volatility throughout history. The great stock market declines are called, systematic or market risk. Events such as the bursting of the tech boom in 2001 – 2002 or the mortgage market melt down and U.S. debt crisis in 2008-2009 cause systematic drops in the major U.S. stock markets.
The Big Investing Mistake
“Many investors—both individuals and institutions—are moved to action by the performance of the broad stock market, increasing stock exposure during bull markets and reducing it during bear markets. Such “buy high, sell low” behavior is evident in mutual fund cash flows that mirror what appears to be an emotional response—fear or greed—rather than a rational one.
For example, from 1993 to the market peak in March 2000, investors’ allocation to stock funds nearly doubled, and in the two years preceding that peak, as the market climbed 41%, investors poured nearly $400 billion into stock funds. Unfortunately, the stock market then reversed rather dramatically and returned –23% over the next two years.” ~ Vanguards Principals for Investing Success.pdf
Vanguard artfully describes how many of its investors make this same big investing mistake of selling after a stock a market drop and waiting to get back in after missing out on the greatest part of the rebound.
The chart above shows the scenario of fear and greed which leads to the big investing mistake of buying high and selling low.
- October, 1998 – buy $100
- May, 2003-sell $85
- September, 2005 – buy $131
- August, 2009 – sell $100
- September, 2013 – buy $165
You’re not going to get rich letting your emotions drive your investing practice.
Prepare For An Inevitable Stock Market Drop
I’m a worrier by nature. I constantly fight against the ‘what ifs’. Despite my anxious nature, I understand the volatile nature of financial markets.
Most of the time, the worry that the stock market will fall, is for naught. Yet, 2018, was a wake up call for investors.
As the Fed began raising interest rates from their near zero level, and trade tariffs began influencing the economy, investors got jumpy. During the past 52 weeks, from January 30, 2018 through January 29, 2019 the SPDR S&P 500 ETF (SPY) ranged from $234 to $294 for a 25% span between the peak and trough. Yet, the S&P 500 index closed out 2018 with a 4.23% loss.
Last year demonstrated stock market reality, asset prices are volatile!
After a 10 year bull market, investors got complacent, and then freaked out as markets dropped.
An older WSJ article quoted Allan Roth, a financial planner from Colorado Springs, Wealth Logic. Allen described meetings with 3 new clients with cash assets of $8 million to $30 million. These investors pulled out of the markets during the 2008 – 2009 market drop and never got back in!
After several years of explosive market growth, those same clients were looking to get back into the stock market.
Their situation sounds remarkably like the big investing mistake of sell low and buy high.
If these wealthy individuals are guilty of this big investing mistake, is there hope for the rest of us?
The Fix for The Big Investing Mistake – The Premortem
The premortem solution is simple. Understand the nature of the economy and investing markets. They go up and down. Realize that it’s extremely difficult, if not impossible, to time the markets and know when to buy and when to sell in order to miss the market drops and participate in the peaks. You’re wise to pick an asset allocation, invest regularly, and rebalance annually-regardless of the economic news.
Gary Klein, a senior scientist at the decision-making firm of MacroCognition, suggests using a premortem technique. In a premortem, you assume that a disaster is inevitable and imagine what may have caused the catastrophe. This allows you to consider what might way lay your portfolio and cause a decline.
After thinking about a big market drop and possible causes, you’re charged with figuring out, in advance, how to minimize the damage.
Imagine that the market will drop 30% during the next year or so.
The decline might be caused by; a terror attack, an Asian economic disaster spearheaded by a falling Chinese Yuan, slowing global growth, a U.S. weather disaster, rising interest rates etc.
Although these possibilities may or may not transpire, after you’ve considered worst case scenarios and their causes, you may look at your investment portfolio in a different light.
Consider whether your investments are allocated to weather a big storm, should it transpire.
If not, figure out why and adjust.
If you’re over-invested in one sector of the economy or world, maybe you should lighten up.
If you’re too heavily invested in the stock market after the recent run up, maybe you should sell some of your equity holdings and boost your cash position.
Maybe your investments have drifted far from your desired asset allocation and it’s time to rebalance.
Or, if you’re too heavily invested in equities, and can’t stomach even the smallest drop in the stock market, then, reallocate to include more bonds and fixed assets in your investment portfolio.
The Premortem Investment Takeaway
Although the future is unknowable, there seems to be general patterns of stock market advances and declines. If you can’t handle too much market volatility and are tempted to make the investing mistake of selling low and buying high, you should limit your exposure to stocks.
Now is a good time to review how you handled the recent stock market volatility.
Evaluate your emotions, reactions and investment portfolio. Use that information to design your investments for the future. Risk is inevitable. Unforseen event happen. You can be better equipped to cope with investing uncertainty by looking at various future scenarios and calculating their impact.
Try out the premortem strategy and see if it helps you keep a level headed investing approach.