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Why Buying Low And Selling High Is Bad Advice

"Buy low, sell high", the maxim goes. The reason this is bad advice is that aside from the huge unspoken problem of determining whether a stock's price is low or high, there is an implicit assumption being made, which is that you should try to time the market, i.e., follow along with the stock's price until you believe it is low, buy it, follow it again until you believe it is high, then sell it. This is a bad idea.

The problem with trying to time the market is that first, it is too difficult, and second, it is unnecessary.

The reason it is too difficult is that timing the market requires you to know what other people are thinking and how they will act on that. Furthermore, there may be far more variables affecting the precise timing of a security than can possibly be accounted for, or even quantified. Take the 2008 mortgage crisis for example: Even the few investors (such as Mike Blurry and Steve Eisman) who weren't entirely caught off guard, and had been saying for years that the bubble was bound to burst, were entirely unsure about how long the bubble could last and when it would finally burst. In the end they did make a profit, but not before losing tens or hundreds of millions on credit default swaps first. Author and statistician Nate Silver provides some more evidence of the difficulty of timing things in his book, The Signal and the Noise.

The reason that timing the market is unnecessary is that the consistency of your stock picks, i.e., your ratio of winners to losers, is all you need to make money. In fact, if you could consistently pick more winning stocks than losing stocks, assuming that your winners generally gain about the same amount that your losers lose, you could turn a small but consistent profit margin that doesn't even beat the market into a large, consistent profit margin, simply by leveraging your stock picks with calls/LEAPs.

There are hundreds, probably thousands of stocks trading out there, which if purchased today, would have a better-than-average gain by the end of the year. So if you were able to consistently pick say, at least seven of those stocks out of ten in January, holding onto them for an entire year, you could leverage this consistent gain to become very wealthy in just a few years.

Thus, your best strategy for making money is to focus your attention on areas of the market that are consistently profitable (not necessarily even consistently beating the market, just consistently profitable), and to do your own in-depth research on maybe 10-15 selections per year.

The devil is in the details, of course. There's no guarantee that you are good enough to pick seven out of ten winners. So make a little test for yourself. Print out the 10-Q's and/or 10-K's for ten companies you've never heard of from last year, read through them, and then make a decision about whether or not their stock will go up. Then check their price history to see how you did. Rinse and repeat. What is your win ratio and how consistent are you? Sure, all of this reading may be time-consuming and tedious, but this is your money at stake. If you're not willing to put in the time and effort to tilt the odds in your favor, you're not investing, you're just gambling. (That is, unless you put your money in an index fund, in which case you are merely lazy, but at least intelligent enough to do no worse than the market.)

For those concerned about diversification, 10 stocks is more than enough to protect you from unsystematic risk. There was a study by B.F. King that found that 50% of a stock's volatility could be explained by volatility in the market index. Another study by J.L. Evans and S.H. Archer found that owning 15 randomly chosen stocks would be no more risky than owning every stock in the market. in his book You Can Be a Stock Market Genius, Joel Greenblatt states that 8 stocks is enough to eliminate 81 percent of non-market risk.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.