The wisdom of buying low and selling high

 The wisdom of buying low and selling high

 

If you want to reduce or even eliminate these psychological barriers to investing wisely, it may be a prudent strategy for investors to add funds that follow the principle of asset allocation.

 

One of my favorite gurus, Howard Marks, whose writing is for everyone to read at oaktreecapital.com and is easy to understand as it is without financial jargon, had this to say about investor behavior: “When things are going well and prices are high, investors rush to buy, forgetting all prudence. Then, when there’s chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And it will ever be so.”

I have also seen that type of investor behavior on many an occasion and during different market cycles in the Indian subcontinent. A general tendency of investors is to invest in equity when markets are surging, while pull out when markets are underperforming. But does it lead to a good investment experience?

Mastering market moods can be daunting

It’s a bit difficult to see this happening all the time in the Indian market, and when there’s so much of investor material that speaks otherwise. Cycles are rarely used well. And to be fair, mastering market moods can be daunting for many an investor.

Marks said that markets are like a pendulum, sometimes extremely optimistic and at other times deeply pessimistic. Both the times you have to act against it. But very often, markets are in the middle of these cycles, and there is no sense in extreme positive or negative stance in the market. One factor that always comes in the middle of making these prudent decisions of acting against the pendulum or staying in the middle is – human emotions. Our first reaction when buying an asset is not to make a loss, which often leads us to make mistakes during buy and sell.

More often, volatility also tends to unnerve those investors who cannot stomach the ups and downs of the markets. As for what my own experience shows us, investors tend not to make investments in a market that is volatile because of the worries of seeing a loss in their portfolios in the short run, and so they don’t have the confidence of investing in equities as an asset class. This lack of confidence usually arises out of their lack of understanding of equities. It is apt to mention here that equity is a suitable investment avenue for long term wealth creation. One should ride the short-term volatility with patience with an aim to benefit from capital appreciation in the long-term.

Using price-to-book value model to one’s advantage

If you want to reduce or even eliminate these psychological barriers to investing wisely, it may be a prudent strategy for investors to add funds that follow the principle of asset allocation. These funds practice "buying low and selling high" as a general rule all the while keeping human emotions aside. These funds invest in equities when markets are cheap and book profits when markets are high. This is totally opposite of what retail investors normally tend to do.

How do you know when markets are inexpensive or vice versa?

One financial yardstick that has stood the test of time is the price-to-book value ratio, which is calculated by dividing the stock price to its book value per share. This model is less volatile as compared to the price-to-earnings ratio. Earnings can be very volatile in some seasons or during shifts in cycles, which tends to make the underlying yardstick of the price-earnings ratio rise up and down during difficult times.

The cyclical shift in 2008 showed us how volatile price to earnings ratio could be. For example, earnings raced up in 2007 when markets were surging, but in 2008 when markets dipped, the earnings dipped as well causing the yardstick to be less reliable. In general, we observed that as book value is a balance sheet item, it is more useful to gauge the intrinsic value of a company.

Essentially, the model eliminates human emotion in decision making. By following a model that is driven by prices and valuation of an asset class, and not by sentiment, investors can achieve the goal of buying equity at low valuations and selling at higher valuations.

A feature of balanced funds that use this objective is that it rebalances frequently and automatically to other asset classes when the book value rises. So, when price-to-book value of equities rise, the model helps to cut exposure to equities as they begin to get overvalued and to re-balance to other asset classes.

This model reduces the human emotion of timing the markets and trying to play out the luck factor as opposed to objectively buying based on principles that follow the value-buying principles.

The price-to-book value yardstick serves one well in the long run, navigating different market cycles, capturing the upside and aiming to limit the downside. If there’s a conservative tilt to this strategy, it’s with good reason because the emotions are kept aside and the price-to-book value shows its potential.

Happy Investing

Source:Icicidirect.com