The Illusionary Wisdom of Buying When Things Are at Their Worst

Posted by Alex Frey (@alexhfrey )

There is a central conflict at the heart of human nature between our hard-wired tendency to fit in with a group ("follow the trend"), and our desire to explain our own actions in a way that makes us seem like unique snowflakes ("march to the beat of our own drum").

Investors face a similar dissonance.

The observable behavior of investors is best explained by a model of naive herd-following. But when you listen to how investors perceive their decisions, you hear the language of contrarianism, or the idea that it is good to buck the trend and "buy when things are at their worst."

This conflict between following the trend and bucking the herd manifests itself sharply at a time like today, when markets are up almost three times from their low only six years ago. Prospective investors have observed those around them making money, and they instinctively want to join the party, but in the back of their mind they are also thinking that the "responsible" thing to do is to wait until the market has gone down before they buy.

But in reality, a naive strategy of "bucking the herd" can be as harmful and irresponsible as a naive strategy of "following the herd." And it's a more disguised and insidious danger. 

Looking back at a chart of the S&P 500 over time, buying when things are at their worst certainly seems like it has been a good strategy. Following brutal bear markets in the late 1970s, in 2001, and in 2008, the market saw some of its strongest gains. Those that bought when everyone else is selling seemed to fair well.

So what could the problem be?

Let's walk through a thought experiment and say an ETF that you are tracking goes from 100 to 70 in a couple of months -- a 30% drop. That seems pretty bad.

From here, one possibility is that the investment rebounds and heads back to 100%. If this were to happen, it would appear to validate the "buy when things are at their worst" view. You are rewarded with a nice ~50% profit for your willingness to buck the trend.

The other possibility is that the ETF keeps going down. Maybe it hits 35, and only then rebounds a bit to 50. In this case, it would have been a mistake to buy at 70, as you would have lost another 50%.

But here's the catch -- when you look back on the situation years later, you will still look at the chart and conclude that you should have bought when things were at their worst. If you had only been willing to buy at 35 when everyone else was selling, you could have made a nice nearly 50% gain! So "Buy when things are at their worst" appears to be validated no matter what happens.

Clearly something here is not quite right. A strategy that is successful no matter what happens in the future cannot be very helpful if your goal is to predict the future!

The disconnect is that what you really want know when living in the present is not that you should buy when things are at their worst. That is true more or less by definition. What you really want to know is when will things be at their worst. And a naive contrarianism does nothing to help you figure that out.

Of course, careful readers will notice that I made this logical error a bit more obvious in this case by choosing the wording of the initial statement carefully. But the other choices are not that much better.

"Buy when their is blood on the streets" sounds like a better alternative, but the difficulty is that there is usually not actually blood on the streets. Or if there is, it is not obvious if it's enough blood to trigger a "buy" signal. It is not specified whether we need rivers of blood, or whether a small trickle of blood would suffice. But the huge subjectivity of the measure makes it absolutely certain that you will be able to look back in the future and pinpoint one moment that was clearly the 'blood on the streets' signal (and forget about all the potential "blood on the street" moments before that did not work out)! 

When Mean-Reversion Fails

One of the supposed logical foundations of contrarian investing is the idea that markets tend to mean-revert. If things are much worse than average now, they will tend to get better in the future, and vice versa.

This has certainly been the case in the recent past, and there are certainly some valid reasons to believe that markets can go through bouts of extreme optimism and extreme pessimism. But it is also important to remember that there is no universal law that says that investments or markets have to mean-revert.

Take this chart of a venerable blue-chip company, for instance. If you believe totally in mean reversion, this looks like a great buying opportunity:

Lehman

Here's the problem: that chart was actually Lehman Brothers as of August 2008. Here's what it looks like with the next three months attached:

Lehman 2

Of course that is only one company. Perhaps you think the same could not hold for an entire market.

But consider the case of Japan, which has had countless "blood on the streets" moments over the past 25 years, only to bounce back towards its lows again and again. Today the Japanese Nikkei Index stands at less than half of its 1989 all-time high. Anyone buying any of the various "dips" over that period would still be waiting for "mean reversion" to occur.

There is a lesser-known adage that beautifully debunks the idea that if an asset has gone down a lot in price recent, that it must be a good time to buy. It goes like this:

Question: What does a market that is down 90% look like?

Answer: One that goes down by 80%, and then falls another 50%.

If this seems like a misprint to you, I highly encourage you to take a minute and do the math.

For that matter, while the charts are less accessible, there are plenty of other examples of historical markets that never mean-reverted, because they went to 0, usually due to war, hyper-inflation, nationalization, default, or some combination thereof.

Why This Matters: Many Investing Strategies are a Lot Less Sophisticated Then They Seem

The point of this is not to scare you, or to make any kind of prediction that this will happen in the future. But it is to challenge the way that you think about investing. If you are relying on a naive mean-reversion strategy, you need to reconsider your assumptions. Buying because the price has gone down recently (or alternatively, not buying because the price has gone up) may have the illusion of sophistication, but it is just an illusion.


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By Alex Frey