When should I buy stocks for my portfolio?
By now, readers of this article series will have asked themselves key questions about what they seek to achieve from an investment portfolio. They will have an idea of how many stocks they will be aiming to hold, how much cash is ideal for them and be able to determine how they should be weighing their portfolio. One of the biggest remaining challenges is to decide when to take action and purchase a stock.
At the end of the day, this will depend a lot on the investment style that an investor prefers. Some investors will feel more comfortable buying when a stock is weak, where it is easy to buy in size, and the potential for outsized returns on any rebound is significant. However, this behaviour will be anathema to other investors, who prefer to wait for tangible signs that a stock is performing before jumping on board. Neither way is necessarily correct for all investors, and both have pitfalls that investors will want to avoid if they are to be successful with their strategy.
Before exploring this further, there is one general principle that investors should keep in mind:
Now is better than never
As explained earlier in this article series, most investors have terrible market timing instincts. Attempting to time the overall market costs the average investor around 1% per year of return. For investors in more volatile assets such as technology funds or individual stocks, attempted market timing will likely cost them far more.
It is easy to find reasons not to invest at any given time – concerns over the economy or interest rates, changes in government or tax rates, the list is virtually endless. Many of these may be genuine reasons to be cautious, and some may lead to a stock market sell-off. The problem is that Investors spot too many crises and sell up too often. This tendency probably originates in our history as hunter-gatherers. Those who spotted an imaginary tiger in the jungle and ran away merely faced the consequence of some unnecessary spent energy. Those who failed to spot a real tiger faced a much more severe consequence and didn't last long enough to have much impact on the gene pool. Today's investors are the ancestors of those who often over-reacted. They tend to see tigers in the market far more often than they actually appear.
With genetics stacked against investors, it is certainly possible that the time to buy is always now. Once an investor spots an investment that meets all their investment criteria, they may be better off buying it immediately to bring it up to their target weighting. This is particularly true for those investors who do a lot of research but struggle to pull the trigger. For these investors, now is better than never.
Not every investor will feel comfortable buying a full position immediately. For these, a more nuanced approach may be appropriate.
Averaging Down (or Up)
Averaging down means investing an initial amount and then adding to the position if the stock drops by a further percentage. The logic is sound; if an investment is sufficiently undervalued for an investor to consider initiating a position at a specific price, then by buying more at a lower price, the investor must be getting an even better bargain (assuming that there has been no deterioration in the business's economic prospects in the meantime).
Despite being logically sound, averaging down gets a lot of bad press. Many investors quote the likes of great investors such as Warren Buffett, who is most associated with the maxim, 'Don't garden by digging up the flowers and watering the weeds'. In this case, Buffett is actually quoting Peter Lynch, who suggests averaging down in good stocks. It would seem that Lynch and Buffett's 'flowers' are businesses with sound economics that are performing well, and their 'weeds' are badly performing businesses.
The real issue with averaging down is the power that losing investment has to cause irrational behaviour. This is due to a behavioural bias known as loss aversion. Investors are risk-averse after making gains but become risk-seeking when facing losses. This means the average investor snatches gains too early and holds on to losing investments. This can lead to averaging down aggressively, even on stocks where the investment case has deteriorated significantly, in an attempt to avoid a loss and get out even. This is rarely successful.
The risk of getting this wrong means that many investors only consider averaging up, adding to a winning investment. While this may avoid some of the issues surrounding loss aversion, this is not necessarily logical either. Any particular investor's buy price is essentially arbitrary and holds no predictive power for the future direction of the stock price. This may be a sign of share price momentum, but investors would be better off screening for this directly if they want this exposure.
There is evidence that averaging down is a successful strategy. Lee Freeman-Shor, in his book The Art of Execution, analysed 31,000 trades of 45 professional investors. He found that how they responded to price declines was one of the critical factors in determining which investors made money over the long term. Investors that use stop losses to limit the impact of losing investments on their portfolio he calls Assassins. These killed a losing investment before it did any real damage, selling when the price dropped by 20-30%. He calls those who averaged down Hunters. Their ability to add to losing positions often generated a profit on investments even if the stock never rose above its original buy price. The losing strategy was doing nothing in response to a price decline. He calls these Rabbits – they are run over by the market.
When adding to a position slowly, and particularly when averaging down, there are a few principles that will improve investors' decision-making:
Add cautiously
Investors often anchor on the current share price. It can be hard to conceive that a stock could fall 20%, let alone 50% or more. Therefore, investors should set themselves demanding levels that they will consider adding at. For example, an investor may add every time the stock falls 10% or 20%, with the aim of only being fully invested if the stock has fallen 50% or more. In my experience, these challenging targets are often achieved.
Limit the amount that will be added to any one stock or sector
While sensible investors have portfolio limits that restrain their exposure to any one stock, there is a way that they can lose far more than that: by averaging down. Hence, it is worth keeping track of not just the proportion of the portfolio in a single stock but also how much money has been put in at cost. If this figure approaches the portfolio limit, it is time to stop adding. Knowing that an investor has this limit set should lead to caution in averaging down and help reinforce the first principle. In this case, applying the same principle to sector limits, too, is wise.
Avoid averaging down in companies with high leverage or at risk of obsolescence
Australian hedge fund manager John Hempton has cautioned that investors should avoid averaging down where the company has significant financial or operational leverage. When things go wrong with such businesses, they tend to do so quickly, leading to total losses. Adding more on the way down is a recipe for disaster. Likewise, companies suffering from technical obsolescence should not be averaged down into. The chance of the stock never recovering is too high.
The trend is your friend
For many investors, the idea of averaging down fills them with dread. Instead, they look to buy when the prospect of further significant declines looks unlikely. This typically requires some kind of trend-following strategy.
Momentum
Perhaps the simplest strategy is price momentum. It has been well known since the 1990s that the strongest performers from 12 months to 2 months ago tend to outperform the market. The Stockopedia Momentum Rank captures this effect, together with measures of fundamental Momentum. Buying stocks where the recent price change is strongly positive, and the fundamentals have been improving is a winning strategy. (Although the rebalancing costs mean that Momentum funds have never managed to live up to the results the academic literature suggests.)
The problem with using Momentum as a buy signal is that investors may be waiting a long time for their stock pick to reach the heady heights of a top Momentum Rank. So unless an investor is specifically a momentum stock picker, they may want to set their sights lower and invest when the Momentum Rank is above 50, with an improving trend.
Relative Strength
One way to ensure that an investor is going with the trend is simply to demand positive relative strength over the past year. This means that the stock has outperformed the general market over this period. Positive Relative Strength is one of the inputs in Jim Slater's Zulu Principle. This is most famous for its use of the Price Earnings Growth (PEG) ratio. While these factors are often used as screening criteria, Relative Strength can also be used to time stock purchases that are selected via other methods.
Moving Averages
There are a few popular ways of calculating moving averages: simple, weighted or exponential. However, all of these do the same thing: they capture the recent trend of stock prices. The typical strategy involves buying when a stock price moves above the Moving Average and selling when it dips below. More complicated strategies use two moving averages; the buy signal is when the shorter-formation-length moving average rises above the longer-formation-length one.
In his book Stocks for the Long Run, Jeremy Seigel shows that a trading strategy using the 200-day moving average generates a slight outperformance vs the general market. However, it has the added benefit of avoiding big market crashes, hence also adding value in other ways. In 2003, Paul Merriman tested whether a 100-day moving average could yield higher percentage returns than the NASDAQ. He concluded that the moving average strategy generated a whopping 6% annual outperformance versus the index. However, many moving average studies face pushback from academics for data snooping bias. Researchers know the outcome, so they can test many moving average periods until they find one that works.
The most popular moving average pairs are the 50-day and 200-day. When the 50-day crosses the 200-day with both rising, this even has its own name: the golden cross. (The death cross is the counterpart when the 50-day goes below the 200-day with both falling.) These are meant to be highly predictive trading signals.
However, it seems that the 50-day moving average may be a little long. A recent December 2023 study called Moving Average Distance as a Predictor of Equity Returns used the 21- and 200-day moving averages. The authors, Doron Avramov, Guy Kaplanski, and Avanidhar Subrahmanyam, tested if these predicted equity returns for U.S. common stocks listed on the NYSE, AMEX, and Nasdaq. They found that the outperformance ranged from 5.43% for the 12-month holding period to 8.35% for the three-month holding period. The results were robust for the 5-day to 35-day range combined with the 200-day moving average.
With results of this magnitude, it seems like we should all be timing our buys and sells using the 21- and 200-day moving averages. However, there is a nuance here that may be missed. The authors were not using these signals to time buys and sell but instead investing in the top decile of stocks as measured by the gap between the 21- and 200-day moving averages. (And shorting the bottom decile.) It is clear that investing in stocks where the 21-day moving average is significantly above the 200-day is a great place to be, just that the cross itself may not signify a particular point to invest.
Conclusion
As with other aspects of investing, there is no one time to buy that works with every strategy. The key is to determine which methodology fits an investor's psychological makeup. For many, this will involve waiting for price trends to establish themselves before initiating a position. Those who are more contrarian by nature will prefer a cautious averaging down strategy to scale into a position. Those prone to excessive inaction may benefit from simply acting as soon as an opportunity presents itself.