We use a lot of sayings, often contradictory, in finance. We say “don’t fight the Fed” or observe that “bulls make money, bears make money, but pigs go to slaughter.” One that I have been thinking about lately is “catching a falling knife.” That saying derives from the fact that buying low and selling high is one of the hardest things to do. If we grasp too soon, we get cut. We might also be fooled by a “dead-cat bounce” which turns bloody when we mistake a brief rise for a reversal.
Psychologically, we are not built to buy low and sell high. Markets tend to peak when people are consumed by the “fear of missing out” or FOMO. Prices go higher, we kick ourselves for not buying, then we buy, prices go up and we have confirmation that our decisions are correct. We find ourselves in a “crowded trade,” which is how bubbles are born.
Buying low means knowing that prices could always go lower. Instead of confirmation, we have regret. We beat ourselves up for making a bad decision. We can’t brag to our friends about our brilliant moves.
Ultimately though, long-term performance depends upon price. When prices are too high, our expectations over five or ten years are diminished, at least when we are thinking rationally. The long-term outlook for houses was much better in 2009-2010 than today. Houses could be bought for half of the cost of construction, with the land thrown in for free. Nobody wanted to buy then. Today, we have bidding wars again. The building that I am in right now was bought in foreclosure for almost half of what the previous owner owed. Our office on 17th street was also purchased in foreclosure. The value was never going to go to zero, yet nobody bid at the auction.
Since we are all human and subject to similar cognitive biases, we need to develop systems that prevent us from falling victim to FOMO. Since some companies do go bankrupt, we protect ourselves and diversify by buying a bank fund instead of a bank stock. We also make sure to buy investments that make sense within our objectives. We remember why we own investments in the first place. If we buy something because it has good dividends, lots of tangible assets, low debt, and because we need the income, the fact that it is not in favor with momentum investors (MOMO) doesn’t mean anything.
If we have diversified portfolios, properly allocated to our risk level, we will always have investments that are down. Many people will sell them and buy what is already high. For example, we may desire to hedge the dollar against inflation and buy investments denominated in euros, loonies, or yen. If we still believe that we need a hedge, and if we are receiving good interest and dividends, it makes sense to take some profits out of our top-performing asset class (sell high) and add to our out-of-favor asset class (buy low). We are now able to avoid catching a falling knife or rushing into an ultimately doomed crowded trade.