The Bottom and The Top

Aaron Brown of AQR gave a presentation in 2013 for the New York Society of Security Analysts. He said some things that are counterintuitive and controversial like “the more you pay for stocks, the safer they are” and “credit spreads are safe when they’re low and risky when they’re high.” It’s understandable to question these statements, especially given that the data he backed this up with only looked out ten days, but there is far more truth in these ideas than people are comfortable with.

Momentum makes people queasy because investors are naturally paranoid, and it’s this natural paranoia that makes it so difficult to let our winners run. Quoting Jesse Livermore is easy. Watching a 70% gain turn into a 10% loss is excruciating.

Have you ever spoken to anybody who said “I got a stock tip and I tripled my money. What do I do now?” Me either. This is why the “if you invested $10,000” thing is so ridiculous.

$10,000 invested in Netflix ten years ago would be worth $996,000 today, but if you or I actually invested $10,000 in Netflix ten years ago, we would have sold it for $7,500 three months later, or we would have sold it four months later after it rebounded for $10,300. Either way, hanging onto a 100 bagger is something few people will ever accomplish.

Consider somebody who has been sitting in cash for the last few years, waiting patiently for the market to pull back. Watching from the sidelines for too long during a bull market has a crippling psychological effect. At some point(s), you’ll be tempted to buy stocks, but will be turned away by the internal “Oh, just my luck that I’ll invest and then the market will top.” Investors always worry that something is lurking around the corner, so we overestimate the likelihood of buying at a top. This person, in theory, would be more comfortable putting money into the market after a decline. But they would never think, “Just my luck, I’ll put in money and stocks after a 30% decline, and then they’ll fall another 30%.” This wouldn’t occur to them because the first “rule” of investing is buy low sell high, so we naturally become a bit brazen when stocks are going down. We’re doing what we think we’re supposed to be doing.

If we overestimate the likelihood of buying at the top, then we really, really overestimate the likelihood of buying at the bottom.

Brown says

People are afraid of two things. You’re afraid of buying at the top. And you’re also eager to buy at a bottom. Well both of these things are legitimate, but if you buy at a top, it doesn’t kill you, it really seldom does. If you buy at a top you’re gonna take a loss but it’s not a huge loss, and generally the odds are in your favor. So I’d tell people, don’t be too afraid of buying at a top. If you’re looking around and you’re saying id like to get into this but I think its a top, that’s not such a big fear. You can live with that. But if somebody says to me I’m sure its the bottom I’m getting in, I say well ya know, why don’t you go walk around the block a few times. That’s a very dangerous play

It might be true that the less you pay, the more you get over the long-term. But what’s also true and far more important is that the less you pay, the harder it is to hang on.

Take for example an investor who sat on his hands during the late stages of the tech bubble because they were confident that it was unsustainable. So they waited for a 50% decline in tech stocks, which arrived in January 2001. If they bought the NASDAQ 100 after a 50% decline, they would then have experienced another 67% decline over the next 21 months.

Or consider somebody who was cautious on stocks in 2007, and wanted to wait for lower prices before getting bullish. If they bought the S&P 500 in October 2008, after it experienced a 30% decline, they would have had to endure another 40% decline over the next five months.

The irony about of being bearish for too long is that these people turn bullish too early. It’s easy to mistake a bruise on the arm for blood in the streets. Here is Brown again.

I think the true rule is if you buy things when people are fearful you’re taking a lot of risk and you’re typically not getting a very good return. You have to actually get down there where people are most afraid. Only the real blood in the streets. Only the real most fearful times do you actually get paid for taking this extra risk. If you buy things when people are just kind of fearful but not panicked you’re getting no expected return and you’re taking a lot of risk. Not as much risk as when they’re completely panicked but at least then you get paid for it. If you buy things when people are smug and relaxed, everybody says that’s when you have to worry…People say it’s incredibly risky. Well it isn’t. Statistically it’s not. When everybody’s smug and happy and not looking for anything and thinking things can only go up. It’s pretty safe. And you get paid for holding things.

Brown ends his talk with a few takeaways.

  • Long investors: take your losses and let your profits run
  • Short investors: it’s complicated
  • It’s easier to survive a price drop after buying at (what turned out to be) the top, than after buying at (what you thought was) a bottom
  • Things are usually expensive for a good reason, bet against it only with a better reason
  • Things are often cheap because there are no good reasons, bet for or against it at your own risk

Watch the video below.

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