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Is It Really That Simple To Buy Low And Sell High?

The decades-old adage in the stock market says “Buy Low, Sell High”. This seems to be common sense and some people regard it as an utter waste of time to even mention this phrase. However, there is more to the phrase than meets the eye, because time and again I observe how investors end up buying high and selling low instead. Why is it so difficult to adhere to this seemingly simple piece of investment advice? Let’s explore this below.

Let’s start off by first defining what “low” and “high” actually mean. In the absence of any objective measure or a numerical value, the two words can be very arbitrary and result in considerable confusion.

“Low” should actually refer to low valuations, and not just a low share price. Valuation refers to the price-earnings ratio or price-to-book ratio of a company, and measures how expensive a share is in relation to the profit it generates, or the assets it owns. Hence, a company with a share price of $0.01 may still be “expensive” if it is loss-making, as the continued deterioration in the business may eventually make the company worthless. On the other hand, a company with a share price of $50 may actually be “cheap” because it can generate, say, $25 worth of profits in one year, meaning you can recover your investment back in just two years! Low and high should therefore relate to valuation metrics rather than an absolute share price, and this makes it a little easier to understand.

But how should one define “low” and “high” and is there any threshold to benchmark against? One way to assess this is to look at the five-year average valuation for a company and to see if the current valuation exceeds this trend. If yes, then the company may be more expensive than it used to be, on average. While this is obviously not a foolproof method (as the company may have heightened prospects for much better business performances in the future, which explains the rise in valuation), it does provide some guidance on how to assess whether a company’s valuation is high or low.

The final and most difficult thing to do would be to actually execute the buying and selling once we establish that the shares we bought cheaply are indeed getting expensive. Psychology plays a major role here – we may hold back from selling due to purely sentimental reasons (in other words, we have fallen in love with the stock), or we may worry about suffering from regret if the share price continues to climb after we sell.

So after going through the evidence above, it is really not so simple to “buy low, sell high”!

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.