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A Beginner’s Guide to Buy Low, Sell High

A Beginners Guide to Buy Low, Sell High

 “Buy low, and sell high”, is foundational advice often given to beginning investors in order to avoid losses and lock in gains.  In an attempt to reach that goal, a portfolio manager often draws from the discipline of technical analysis which at its core, focuses on the effects of buying and selling pressures on assets such as stocks, bonds and commodities.  Technical analysis is often contrasted against fundamental analysis which focuses on gauging the financial health of a specific company or industry.  The two can also be blended, introducing an additional discipline, economic analysis.  This post will explore the technical analysis discipline which is diverse.  However, most technical analysis tools can be separated into either trend following or mean reversion categories. 

Understanding how markets move

Markets have two states of movement, either trending up/down or rangebound. A portfolio manager must first use indicators specific to identifying the two states of movement. Think of these technical analysis indicators as tools. Having the right tools for the job plays a significant role in the success of the overall investment process.  Like using a hammer to drive a nail or a shovel to dig a hole versus using the shovel to drive a nail and the hammer to dig a hole.  Once an environment is identified, more specific indicators and methods can be used which may reveal further information about the environment.

Indicators of market movements

Indicators are available to detect various traits of price movement.  If “Point Z” is higher than “Point A”, then an uptrend may be present (though what happened in between could play a role in the investment decision).  Trends may be steady or could be choppy.  Even within a choppy uptrend, it may have various degrees of width in the swings.  Indicators exist that simply define a trend as being positive or negative and tools exist that define the level of volatility within the trend.  Rate of change indicators can identify the percentage movement over a specified time period in order to identify trend.  These indicators also display momentum or if the trend is speeding up or slowing down. Why does all this information matter? The more informed you are as to what is going on with a market environment the better equipped you may be to make risk-adjusted decisions for your portfolio.

Moving Averages

Moving averages (displayed below) are popular ways to identify trends because chart readers can easily see if the asset is above the moving average or below. If the asset is above the moving average the trend can be defined as an “uptrend”.  If the asset is below, it can be labeled as a downtrend.  The number of days used to calculate the moving average can vary in order to detect trends of various time frames such as shorter-term, intermediate or longer-term.

200 day
Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved

Mean Reversion

The “buy low and sell high” concept can also be conveyed through mean reversion methods.  In case that term is new to you, mean reversion simply means the movement is stretched, gone further than it typically does, and may soon snap back.  “Overbought” and “oversold” are common terms associated with mean reversion methods.  If a stock is in a trading range, by definition, it reaches an upper point, or extreme and then goes down toward a mean or average.  It may then overshoot and go to a lower extreme, becoming oversold and then revert back higher.  This process may be repeated numerous times.  Trading ranges may be after an uptrend or downtrend has slowed.  These may lead to a full reversal in overall direction or the trend may eventually resume but at a different slope.  Once a trading range is identified, a portfolio manager must then be able to identify what constitutes the extremes or overbought and oversold zones.  Tools of the trade may include Stochastics, Money Flow Index, and RSI, among others (pictured below).

RSI Money Flow
Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved

Volatility Analysis

Tying the states of trending and trading ranges together may also involve volatility analysis.  If volatility is high enough a trend may be observed and at the same time, upper and lower extremes can too.  These are often referred to as trend channels (see below).  Modest adjustments to exposure are often the goal when trend channels are identified such as the adding of positions around the lower channel line or “profit-taking” near the upper channel line. 

Trend Channel
Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved

Why does this matter?

Many investors take a hands-off approach to investing but that puts hard-earned money at the whims of the changing trends, and some bear market trends can be devastating.  Active portfolio management, by way of technical analysis, often includes implementation of the tools discussed above. These tools detect periods of trending or trading ranges.  Refinements with more specific trading tools and methods within those periods can further increase odds of potential success in navigating the unknown waters yet to be seen. This comprehensive approach to investing is used in Spectrum’s management for its clients.

Know Yourself: The Four Investment Temperaments

I recently read “The Four Temperaments” by Rev. Conrad Hock, AngelusPress.org.  In it the author describes in detail the good and bad traits of each of the four temperaments: choleric, sanguine, melancholic and phlegmatic.  Everyone has a dominant temperament, and, in the book, you can take a simple test to find your own temperament.  There are also many online sites that allow you to take a test to determine your temperament.  Unlike personality, your temperament never changes with time!

The fact of the matter is we are all emotional.  But we all react in different ways when presented with unintended consequences, surprises, conflict, decision-making etc. (both good and bad).  I started working with clients and their investments back in the early 90’s.  It amazed me how clients reacted differently to the same 20% move higher or the same 20% move lower in the market, even when they had the same risk tolerance.  Most of these reactions were based on perceived expectations correlated directly with their investment temperament.

The chart below shows the emotional rollercoaster ride millions of investors go through from time to time, which may influence investment decision-making.  In many cases the decisions investors make can be quite irrational and detrimental to their long-term portfolio goals.  Many investors don’t have the expertise and certainly not the time or focus needed to make proper investment decisions.

September 2015 edition of ICICIdirect Money Manager Magazine.  Source: Credit Suisse

Behavioral Finance is an amazing topic.  There have been numerous books written and any Economics/Finance major has taken at least one course on this subject.  I won’t turn this into a 50-page thesis, but I would like to explain four investment temperaments I have coined over the last 25 years.  These observations include clients, prospects, family, friends and strangers.

  • Risk Seeker This type of investor wants to make as much money as possible, regardless of risk. This type wants to make make at least as much as the general stock market going up.  On the way down they aren’t happy, but they won’t sell, knowing they will make back their portfolio losses and then some in the future.  They are extremely confident individuals.  A spin-off of the risk seeker is one that has the same objective, however their reaction during large drawdowns is different.  They start to panic, even though they came in with a long-term game plan. They know the risks involved with investing aggressively, but eventually they will sell everything at the worst possible time.
  • Controlled Risk-Taker This type of investor wants to make all the money when the general market goes up but wants to lose very little during drawdowns. Much of their investment portfolio is in equity positions.  These investors are typically well informed on what the general market is doing.  Buy and hold won’t work during periods of large drawdowns, so they employ active management in bad times.  They will quickly reduce portfolio equity exposure at early signs of emotional pain.
  • Preservationist This type of investor wants to make money with much less risk than the stock market. They feel safer with bonds because they aren’t as volatile.  Many investors with this mentality either fear they will run out of money in their retirement years or they want to give it all to their children/grandchildren.  They simply want to be reassured that their principal is still there.  Any growth is a positive.
  • Balancer This type of investor wants to make money in line with stock market returns, but they want downside protection. They know stocks are riskier than bonds and the next bear market will eventually come. They like being in a diversified stock/bond/alternative portfolio.

In late October the S&P 500 gave up all its gains for the year in just a few weeks (see chart below). From the close on October 3rd to the close on October 29th, the S&P 500 fell 9.71%. The Nasdaq 100 Index fell 12.09%, led by one of its largest components, Amazon (AMZN), which fell 21.19%.

Created with StockCharts.com.  © StockCharts.com, Inc.  All Rights Reserved.

The most common reactions I heard at the end of October were:

“Everything is fine, it’s time to buy more at a discount.”

“Ouch, that hurt. I don’t know if I should sell or hold here.”

“This doesn’t feel good, but at least my exposure was reduced, and I had a diversified portfolio, including bonds.”

“Is this the start of the next Bear market?!?! Is my money safe???”

“We’re still in a Bull market. I’m diversified and this bump in the road is OK.”

“I’ve enjoyed this Bull market, but this is the second time this year I’ve seen a 10% drop.  I think it’s time to be a little more defensive, unless the market has a good rally.”

As stated before, you can see many different reactions to the same 10%+- move in the market.  All these reactions are normal, depending on your temperament.  At Spectrum Financial one of the first things we talk to prospects about is their risk/reward profile.  Investors must be honest with themselves when asked questions like:

  • What is the biggest drawdown you could handle?
  • What are your long-term goals? How long are you willing to invest with us to meet them?
  • What Index(s) will you compare your portfolio to?
  • Is your outlook generally optimistic or pessimistic concerning investing?
  • Do you feel you are an aggressive, moderate or conservative investor?

I tell prospects and clients all the time that there are no wrong answers to the above questions.  If these questions are answered honestly, it’s much easier to customize a client portfolio based on his/her temperament so that expectations are met.  Once allocated, we know we are doing a good job when we see a drawdown in the market like we saw this October and our clients are happy with their return based on their risk/reward expectations.  If a client calls disgruntled, in many cases they aren’t as aggressive/conservative as they thought they were.  We can easily adjust portfolios accordingly.

What type of investment temperament do you have?  Call our office and let us explain our unique investment products and how they can be a great fit for your investment portfolio.

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Spectrum Financial, Inc 2019