Why We Buy High Sell Low
I read two very good quotes today (that are interrelated even though spoken by different people) regarding asset pricing. I believe these quotes apply to all types of assets from stock and bonds to commodities and real estate.
Appreciation always eventually reverts back to the mean. Unfortunately, when prices have gone way over average, they have to go below average for a time in order for the mean to reestablish itself again.
Prices may be fairly valued, but whenever you have a bubble of huge proportions, valuations do not simply revert to the mean, they overshoot it and become grossly undervalued.
Whenever prices climb people start believing that prices will continue to climb. So everybody and their neighbors jump in the bandwagon and try to grab a piece of the action (and make a quick buck). This grossly pushes up demand and throws supply out of whack, causing prices to rise even more.
Eventually people realize that the asset is way overpriced and tries to get rid of it as quickly as possible, causing a sharp dropoff in demand and making it underpriced. But sooner or later, prices will revert back to the mean to its true valuation, balancing both supply and demand.
So the best time to make money is to buy when it is undervalued and sell when it is overvalued. Buy low, sell high. Seems like an easy concept but why do so many people fail at it? Because of the herd mentality. We flock toward assets that other people buy, but by that time most of the gains have already been had. And we get rid of assets that other people don’t want, locking in our losses.
I think it is important to research the true valuation of assets instead of looking towards other people to decide which assets to buy and sell.
If from research we find that assets are undervalued then we should still invest in it even if other people are running away from it, most likely the asset price has become grossly undervalued. On the other hand, if through research we believe the asset’s value does not justify its high price then it is time to sell, it probably has overshot the mean and is in a bubble.
Related posts: