By Steve Tepper, CFP®, MBA
This is the story of four investors and a fictitious company completely unrelated to one in the news recently, LameSlop. LameSlop stock is selling at $20 per share in January, and investors A and B both buy it. They both believe the stock will go up in value.
Over the next couple of months, the stock drifts down in price. When it hits $10, investor B decides to “cut his losses,” and sells. Investor C gladly scoops up the shares because she believes the stock is due for a rebound.
A short time later, LameSlop takes off! Over the next few weeks, the share price rockets up to $100! Investor C is glad to take a monster profit and sells her position to investor D, who thinks the big rally has just started.
The frenzy that drove LameSlop shares up dies off, and the price tumbles back down, settling off around $30 per share. Bitterly disappointed, Investor D sells.
Here’s an easy question: Who made money? If you said Investor C, you get half credit.
To summarize: Investor B bought at $20 and sold at $10. He took a 50% loss. Investor D did even worse, in at $100, out at $30, a 70% loss. Investor C did OK—a 900% return in about four months!
But someone else made money too! Remember Investor A? They got in at the beginning at $20, held firm as the stock sank, kept invested during the big spike, and even though they were still holding to the end, they are now sitting on a 50% gain at $30.
Is 50% as good as 900%? Of course not. But the better question is, what did Investor C do better than Investor A? Was she skillful to predict the price would go up and then get in and out of the stock at the right time?
It’s worth pointing out that when Investors B and D bought in, they also thought the price was going to go up. Which brings us to an important rule of investing: No one buys a stock because they think it will go down in value!
I don’t know—maybe there are some people who invest with no intention of making money. I’ve never met one of those people, so based on my experience, I’m going to have to conclude people select specific companies to invest in because they think the price of the stock is going to rise.
All four investors in our scenario did. Investors B, C, and D went one step further and tried to time their entry and exit. All three had the same strategy: Buy low, sell high. (I didn’t say it was a sophisticated strategy.)
It turns out Investor B was half right. He bought low. But he didn’t buy at the lowest and got scared when the price fell. He bought low, sold lower. Not a good investment strategy.
Investor D was wrong on both his entry and exit. He bought high and sold low, and got slaughtered.
And then there’s Investor C, in low and out high, perfectly executing the strategy!
Nothing is clearer to me than this: Three investors using the same strategy, one wins big and two lose big. What distinguishes Investor C? Luck. Just dumb luck. Without the benefit of being able to see the chart in advance, C just happened to guess right … twice.
Guessing isn’t a sustainable investment strategy. There’s no reason to think Investor C has any better chance of guessing right on her next stock pick as any other investor.
Investor A, on the other hand, had a different strategy. Buy and hold. Allow their investment in LameSlop and hundreds or thousands of other companies to grow over time. Not be concerned that this one stock may fall in value because any or many of their other investments may rise in price.
And history tells us that over time, the value of a large basket of investments will grow. Maybe not at the rate of a SpaceX launch, but good enough to construct a solid lifelong financial plan around.
The difference between Investor A’s strategy and the others is it is completely implementable and controllable, with the luck factor removed. When people compare the stock market to gambling, my usual answer is ”Yes, I agree. Depending on your strategy.”
If you follow a strategy that will likely lose money, you’re gambling. With an academically derived strategy that gives you a good chance of making money over time, you’re not.