Saturday, June 6, 2009

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Buy at the Bottom or Buy When Everyone is Selling: A General Misconception of a Stock Trader

One of the fundamental principles that Warren Buffet had taught and had been accepted by the investors across the world about stock markets, is to buy stocks at the bottom. He does not explicitly talk about the bottom. But he says that one should buy when everyone is selling. I found many people backing up their temptation to buy stocks using this theory. Though I agree with the principle, I find that many traders and investors alike have a misconception about this theory. I will give you a paradigm shift to understand why you may misunderstand this theory.

a funny stock market index cartoon, falling 2008 index reversedImage Source

Not on the Surface

Many investors and traders take Warren Buffet’s principles without a second thought. No matter who is sharing the stock trading principles it is highly important that you as a trader analyze from your own perspective and learn new perspectives if required. It may happen that certain principles can shift your basic paradigms that you might have had for many years.

There are some principles of Warren Buffet that cannot be applied when trading stocks. Mostly it is to do with the difference between his mindset and a trader’s mindset and fundamental beliefs. The personality traits, emotional behavior, cognitive abilities all differ from person to person. And thus always play a role in influencing a trader and an investor in different ways.

When you buy stocks for the first time you will not know whether it is bottom or top. You will not be able to tell whether it is at a high price or a low price. Because all these are only relative terms. There is a fundamental and unique aspect about stock price movements that makes it difficult to understand than any other phenomenon.

You can Not Tell Till You can Tell!

You can never tell when a stock has made a bottom until it conclusively proves by moving much further up away from a certain lowest price. There can be bottoms in intermediate time frames, short term trends, and long term trends involving 5 or more years of time period. For example, the present market (Sensex at 15K) has moved much farther away from its lowest value in the past few years of 8K. Of course all this happened in only five months of time. But nevertheless you could not tell that 8K for Sensex was the bottom conclusively till now.

This is where the stock market behavior differs from other disciplines. Stock trading involves the fundamental and fourth dimension of time. It is its time varying behavior that makes it so tough to decode its Da Vinci Code. You cannot tell so and so not only until it happens but also after enough time that the opposite happens.

When traders buy stocks as they fall they say that they are buying the stock at the bottom. They also refer the name of Warren Buffet to indicate the authenticity of their action. But they do not think once that there can be misconceptions as to any successful theory. If something is obvious in the stock market, then even before you can act there will be so many people already acting on that.

It is not something that is obvious but we need to read behind the lines. When it comes to buying a stock at its lowest price or when it had hit bottom, it is truly to buy a stock at its best possible price for a buyer. But it means the worst possible price for a seller. Then why in the hell a seller will sell the stock when so many buyers are so eager to buy it at the bottom?

Why is This Misunderstood?

The theory is not as simple as it sounds. Many traders and investors alike build misconceptions about it. The same reason holds for the seller that holds for the buyer as well. If buyer thinks it is bottom, then seller too can think so. But if seller thinks that it is not bottom then buyer too can think so. When they think opposite, that is when a transaction or a trade happens.

Now what makes two people or traders who are so similar in their professions, to differ in their thoughts, perceptions etc.? It is the need to take action and not the luxury or proactive nature. A desperate seller or a buyer makes a move for the market but not those traders who think that it is an opportunity. When those traders do act, that does not affect the market much unless the desperate actors have done with their task.

A popular reason why this is misunderstood by many involves the fact that every trader shares similar goals and thus similar thoughts. This results in the theory going into a paradox. Let us take a closer look at this principle.

“Buy when everyone is selling”

I will ask you a serious question, can you really buy when everyone is selling? Think about it. There is a paradox in it. Remember every trader is in the market for the same end goal, that is to make money by making profits, taking opportunities. If you are able to find an opportunity as to buy at bottom, unless you are a very unique individual out of tens of thousands, it is most likely that another trader too is able to find the same opportunity.

If you are willing to buy when others are selling, then there are some traders who are willing to buy similar to you. Then how it is true that you are buying when everyone is selling? The true meaning of Warren Buffet’s statement is that it is not when others are selling that you can clearly see, but it is when you yourself feel like selling even while others are selling.

Unless you too are in the mode of selling, it does not become a situation where everyone is selling. So Warrant Buffet explores a wonderful philosophy here. When you can see your reflection instead of getting trapped by the circumstance like everyone else is, that is when you can successfully control your need or urge to sell and turn around to buy the stocks at the right opportunity.

This is in fact very hard thing to do. That is the reason why Warren Buffet gives away his solid principles for free. It is not just enough to know something. When it comes to stock trading you need to live in the time when the event is happening to fully understand a theory in its true sense.

There is a Paradox in This Principle

As the stock market involves time varying behavior, your emotions, psychology, thoughts, beliefs and behavior too very with time. You feel that a theory fits well with stock market in static state when markets are closed and you are studying. But when markets start moving and the actual scene arrives you will not necessarily feel the same thing.

Now is it not hard to see why this principle is kind of a paradox. If everyone is selling how can there be any person willing to buy? Warren Buffet is referring to the kind of scene that happened in 1930s Great Depression times when everyone including rich, poor were selling stocks. It was a situation where there was no hope for the future. Even the people who normally think steadily and are safe with diverse income streams still go for selling during these times.

That is the time when you should understand that the markets have hit bottom. That is the time when you will not able to find a way to buy stocks even though everyone is selling. It happens on auto pilot. You will feel that you don’t have control over your decisions, but you have to do what everyone is also doing. Can you just imagine such a situation?

Where is the True Bottom?

where is the bottom, DJIA during september 11Image Source

In the present market scenario, I truly believe that such a situation hasn’t yet happened. The simple fact that the markets made a sharp come back by 73% in just two months time from March to May illustrates this truth. People still have the money to buy stocks, they still have the luxury to buy stocks, even in the midst of a recession, there are so many that still have jobs to be able to think of buying stocks rather than thinking about long term future. The bottom is far from visibility.

A true bottom occurs when you, even after knowing what to do at the bottom, will not be left with any choice but to go against this principle. In such a situation to go with this principle is not a simple thing to do. It is a risk that you have to take by sacrificing some important thing from your life or possessions or relationships. But it will be worth doing and only few get the courage to apply this theory at the right time!

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Narender said...

I said it right: " as of today.. the bottom was far from visibility "

Srinivas said...

True. Its a misconception which new investors follow and make losses. Stocks moving down keeps moving down and stocks moving up keeps moving up. In contrary buy stocks which are moving up.

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