Buy High, Sell Much Higher

By Stephan Abraham AAA

One of the tenets of stock investing that the average investor, as well as the sophisticated day trader, has heard repeatedly is "buy low, sell high". Sounds like a reasonable approach to investing, right?

Unfortunately, it is much more difficult than it seems. This is partly because some rookie investors may equate stock investing with shopping at the mall. If a cashmere sweater costs $250 in December but has been marked down to $50 in July, then it must be a good deal, or have some type of value. Maybe so, but stocks are different. If the price of a stock over the last year or so has ranged from $24 to $60 a share and it's currently trading at around $26, it appears to be cheap - so, it's a good value, right?

Not so fast! Buying stocks that are near or at yearly lows may actually add risk to your portfolio, rather than reduce it.

Why Lows May Not Be a "Deal"

  • Beaten down stocks may never recoup their losses or it may take a very long time for the stock to recover its highs. For example, technology stocks such as Juniper Networks (Nasdaq:JNPR) and Yahoo! (Nasdaq:YHOO) soared during the technology bubble in 2000 - and crashed when it burst. By 2008, these companies had yet to recover to their pre-bubble values.
  • The opportunity costs of holding the stock increases over time - if the stock doesn't recover relatively quick enough.
  • Picking the bottom in a stock is very difficult for individual investors. Many investors are lured into a false sense of security when buying beaten down companies, only to be disappointed as the stock continues to fall.
  • You are betting against the Wall Street conventional wisdom when you purchase a stock that is out of favor. In other words, the stock is cheap for a reason: managers of big money do not see the future value in the company at so-called "cheap" prices. In a sense, they are willing to wait for much lower prices before buying the stock.

A Different Spin on the Buy Low, Sell High Strategy
Some investors may want to adjust their strategies to "buy high, sell higher". That's not a typo. Many traders wisely look for stocks that are near their yearly highs and are in strong industries. There are many resources on the internet that allow the average investor to easily find a list of the strongest stocks and the best sectors. However, it should be noted that it is not a good idea to blindly buy stocks off of the new high list. (For more insight, read The 5 Biggest Stock Market Myths.)

Consider these reasons for buying relatively expensive stocks:

  • You are buying a stock that is trending upward, not downward. You are not hoping or waiting on a turnaround story or a buyout. Chances are, your stock has proved its value before you buy it. (For more, see Riding The Momentum Investing Wave.)
  • A stock at or near its high is working with Wall Street money instead of fighting it. And, institutional money moves stocks. Unfortunately, retail buying and selling are not significant market events. Aligning your investments with money managers who manage billions of dollars may reduce the risk that you'll lose a lot of your own money.
  • Cheap stocks tend to trade less frequently. If you own a stock that trades lightly, chances are you may have difficulty finding a lot of buyers at your desired price(s). Stocks that lack volume also lack institutional support. And, as stated above, it's the institutional money that determines stock prices on Wall Street.
  • Making any investment decision solely based on one indicator is not a good strategy. As you find these uptrending stocks in leading industries, one strategy may be to wait for a minor correction of 8-12% before pulling the trigger. This will mitigate the risk of "buying at the top" and therefore provide some cushion for any potential losses that you may incur.

Let's take a look at a well-known company's stock chart over the last few years. In Figure 1, Exxon Mobil (NYSE:XOM) shows a long-term uptrend starting around October of 2006. The oil and gas sectors have been market leaders over this period. On the graph, each circle on the trendline represents buying opportunities along the way. Value investors may have been reluctant to purchase XOM at around $70 per share in early 2007 because at that time, this was near Exxon's all-time high. However, buyers of this stock were rewarded as the shares continued to rise.

Stock chart of XOM, Exxon Mobil Corp.
Figure 1
Source: StockCharts.com

Conclusion
Some inexpensive stocks are actually true value plays and buying them will result in substantial gains. However, buying cheap stocks is not a risk-free strategy. In fact, your risk of losing money may actually increase over time as the stock loses value or fails to appreciate to your expectations. Consider buying strength, and get in on relatively expensive stocks. The risks are not as great as they appear and the potential for upside is consistently better than bottom fishing for inexpensive stocks.

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