Buy Low - Sell High: Putting Theory into Practice

Investment Commentary March 2001
Copyright © 2000 Meyer Capital Management, Inc. All Rights Reserved.

	March 30, 2001	% Change From 12/31/00
DJIA:	9878.78	-8.42%
S&P 500:	1160.33	-12.11%
NASDAQ:	1840.26	-25.51%
Russell 2000:	450.53	-6.82%

If it Sounds too Easy to be True…It Probably is
To many of us, skydiving sounds like it would be a blast, just hop from the plane and float softly to the ground. To others, climbing Mt. Everest drips with the promise of excitement and adventure. In both instances, what sounds great at first takes on a very different meaning when, for example, the moment arrives to throw yourself from the plane or the oxygen on Everest begins to get thin.
So it is with "buy low-sell high." It may be the most basic of all investment axioms. Its appeal is easy to understand because everyone can relate to its simplicity. What isn’t so obvious is the difficulty of putting it into practice.

Investors’ Resolve is Put to the Test
One of the most meaningful benefits a good investment manager can provide for his/her clients is assistance in viewing market events realistically and dispassionately. For the client, whose hard-earned money is on the line, this can be pretty difficult since we’re talking about more than just money. For individual investors, we’re likely to be talking about a sense of security, personal achievement, goals, and dreams. Likewise, institutional investors feel the weight of responsibility for the assets entrusted to their care. If these matters aren’t worth getting a little emotional about, what is? Yet, therein lies the problem, be it fear, panic, greed, or just a loss of patience, emotion makes a poor basis for investment decisions. In fact, most investment mistakes are of an emotional, rather than intellectual, nature.

Today, for the first time in almost 15 years, investors find themselves in the midst of a full-blown bear market. This is foreign territory for anyone who wasn’t an active investor in 1987 or 1981-82, the most recent prior bear markets. The first key to surviving the tumult is coping effectively with the strong feelings that the current market conditions can evoke. During challenging times like these, a brilliant investment decision may be synonymous with avoiding a fear-driven mistake.

While perhaps not immediately obvious, buying low and selling high is intimately associated with the kind of market volatility we’re currently experiencing. Before discussing that more fully, we need some additional perspective. Exhibit 1.1 shows unequivocally that the stock market does deliver higher rates of return over time than alternative investments, in this case long-term bonds. Remember, however, that the length of the investment time period is key.

Contrary to some popular opinion recently, which held that all you have to do is hold some Nasdaq stocks to make loads of money, the stock returns shown above didn’t come easily or cheaply when you look at what investors endured to realize them.

Exhibit 1.2 shows the year-to-year volatility of stock market returns (blue line) since the mid-1920’s. As you can see, the ups and downs occur regularly and randomly. This is normal stock market behavior and it is not possible to predict the pattern. There are two conclusions, each of paramount importance, to glean from this chart:

1. The blue line indicates that, in any given year, it is not unusual for stock market returns to fluctuate +/- 50% and, occasionally, even more. This is what we saw in 1999 when the Nasdaq was up almost 86%. In 2000, it reversed course and dropped 30%, and is down another 30% thus far in 2001.

2. The red line shows that, since the early 1950’s, the average annual return of the market has held pretty steady at or about the 10% return level. This is significantly greater than the historical rate of inflation and the historical rate of return on long-term bonds. Remember also that there were numerous economic recessions, bear markets and stock market corrections during this time period.

People I meet on the street ask me "What’s wrong with the stock market?" I answer, "Nothing is wrong, the market is behaving normally and is doing what markets do." That is to say, they fluctuate, and hidden in the ongoing fluctuation, lies both risk and opportunity. Hence, a basic precept at MCM is that market volatility is not to be feared or avoided, but should be viewed as an opportunity.

Say What?
In modern society, we’ve forsaken mattresses as savings vehicles and we invest our money for two primary reasons. They are to prevent inflation from eroding the purchasing power of our money and to build wealth. Exhibit 1.3 shows that since the mid-1920’s the returns on long-term bonds have been sufficient to offset the negative impact of inflation on purchasing power, but not enough to build much in the way of new wealth. So, if you’re an institutional investor trying to build an endowment fund or a private investor wanting to retire in comfort, long-term bonds alone are not going to get you there.

The difference between the bond curve and the stock curve constitutes new incremental wealth created by investment in common stocks. The question is "how do we get there?" Simply stated, we have to find ways of coping emotionally with stock market volatility.

Let’s look at volatility again, only this time in a slightly different way. Exhibit 1.4 shows the actual volatility of returns, annually, from 1926-1990 for stocks, bonds, and inflation, respectively. You can see that bond returns have been modestly more volatile than inflation. Stock returns, on a year-to-year basis, have been significantly more volatile than bonds.

During short time periods, bond returns frequently under perform the rate of inflation and stock returns frequently under perform both bonds and inflation. Over the long-term, stock returns outperform both bonds and inflation. This is why patient investors win and the impulsive investors invariably lose. Investor patience is the critical ingredient to realizing the rewards.

One final chart demonstrates what has happened historically when investors ignore short-term volatility and remain focused on a long-term investment strategy. Exhibit 1.5 shows historical, cumulative stock market returns. It is clear how patient investors have built considerable wealth despite the Great Depression, numerous economic recessions, several bear markets, and countless stock market corrections. It only looks easy when you smooth out the gut wrenching highs and lows.

The Case for a Balanced Portfolio
A balanced portfolio combines stocks and bonds within the same investment account. Assets can be divided in any proportion between the two asset classes, depending on the investor’s objectives and risk tolerance. Bonds pay interest rather than growing in value over time, as stocks do. So, a balanced portfolio has both an income component and a growth component. One would expect the investment rate of return on a balanced account to fall somewhere in between the stock curve and the bond curve shown in Exhibit 1.3.

The balanced approach works very well and is commonly used by individuals and institutions to achieve a wide variety of investment objectives.

Buy Low - Sell High
Many investors think this common catch phrase refers to deftly calling tops and bottoms in market and/or single security price movements. In fact, it doesn’t. As we discussed earlier, market tops and bottoms occur randomly and aren’t knowable in advance. The buy low/sell high concept is really about overcoming two very powerful emotions: greed and fear. So, while it is intellectually simple, putting it into practice is quite difficult.

For example, think of how hard it is sell a stock that has generated huge gains for your portfolio and continues to appreciate in price almost everyday. You’ve got a winner! Let it ride. Taking some or all of your unrealized gains and rolling them into another investment with a better valuation and greater upside potential, seems crazy. In this case, greed has taken over and is now making the investment decisions.

Conversely, putting new money into the stock market or even remaining invested during a market correction or bear market seems equally ill advised. Stock prices are declining almost every day and the values of our portfolios are dropping right along with them. The popular market pundits all say that the market outlook is poor and that it is the worst time to be invested. Fear, even panic, is widespread on Wall Street.

I’ve heard it said that the stock market is the only place where people get upset when things go on sale. Yet, that is exactly what happens to stock prices during a correction or bear market. Great companies whose stocks were prohibitively expensive to buy earlier can now be purchased for a fraction of their former cost. This dramatically increases the future rate-of-return potential for these holdings and for our portfolios in general.

Overcoming fear and greed poses a challenge for most of us, but it can be done. Again, the solution is to remain focused on the length of your investment time horizon. If that is to maximize investment rate-of-return over say, a 15 or 20-year period, then what happens during any given month, quarter or even full year, isn’t very significant. Look for the opportunity.

Summary & Conclusions
It is not uncommon for market events to become exceedingly complex and threaten to distract us from doing the things that bring investment success. The news media, in particular, fan these flames in their intensely competitive pursuit of viewers. Dramatizing market events obviously works as the success of CNBC, Bloomberg, CNNfn, and the other business news shows would attest.

Our objective is to help you filter out the noise from the markets and the news media so that you can focus on the important things and make objective, well informed investment decisions.

Dealing with the emotional aspects of investing is paramount. Understanding how the markets normally function allows us to maintain perspective. Knowing that patience is an essential element to executing any investment plan, can lower anxiety not only in bear markets, but in bull markets as well. Remember the euphoria of 1999 and the fear of being left out?

Timothy R. Meyer
President