Buy Low, Sell High

Abstract

" Buy low, sell high " is often quoted in finance. While its wisdom is hard to question, its application is hardly extensive. To understand why this is so, it is helpful to put ourselves in the shoes of a typical investor. Let's call him Joe. To Joe, " buy low, sell high " probably means: " I'm gonna find the next hot thing and get it early when its stock price is low. " While that's not a totally unreasonable target, such an endeavour is deeply flawed. To start with, for Joe to successfully find the " next hot thing " he needs extensive and specific business knowledge. Unless he is a genuine visionary (of the Steve Jobs type), chances are quite low that he has deep insights. Those who make a living trying to find the " next hot thing " are called venture capitalists and they expect to lose money on most projects and have a few pay off in a big way. Joe probably doesn't have the required resources to back a large number of investment prospects in the same manner as venture capitalists. But suppose that Joe does indeed stumble on the next hot thing. What are the odds that he will find it early enough? It would be tempting to say he has a better probability of winning the lottery. Even worse, by the time Joe buys shares of a hot stock in the open market, he has probably overpaid for them. After all, a hot stock is one that attracts excess attention from the trading public and therefore commands a hefty price premium. Moreover, the competitive advantage that made a hot stock perform in a stellar manner would most likely attract more competition. The economic law of diminishing returns would kick in resulting in a low likelihood of long-term profitability for the underlying business. For instance, Microsoft was one of the most prominent hot stocks of the 1990's. But since then competitors have caught up with the software giant and market participants are no longer feverishly buying its shares. Ditto for the most recent case of Research in Motion.