Buy on the Upside and Never Buy on the Downside

The following quote by Alan C. Greenberg, a 50-year veteran of Wall Street and the retired chairman of Bear Stearns, a leading brokerage firm, is taken from the Fall 2002 issue of Money magazine, page 124." What I don't understand are people who buy on the way down. Buying on the way down is suicide. I buy on the way up. And then I average up, not down. If a stock is selling at a ridiculously high multiple, I reconsider. But if it's earning money, and management's good, I average up."

Study the following examples to learn why it is imperative to only buy on the upside and never buy on the downside. The examples use the Complete Trading Model (CTM) to compute the percentage of winning trades and average returns for all trades for the three CTM trade types for price series of major market indexes. After studying the following exmples, you will agree that the upside is for winners.

The DJIA - The Bull Market and Beyond

The great bull market for the DJIA ran from August 1982 to the peak of 11,723 for the January 10, 2000 weekly close. After the peak the DJIA went into a bear market decline.

From August 1982 to December 2002 there were 565,516 weekly trades that produced 94.95% winners and an annualized return of 12.24%. This period included the price run up, peak and the three-year decline for the DJIA. The 20-year period gave most investors profits even with the three-year decline in prices.

From the August 1982 through December 2002, 94.34% of the 565,516 weekly trades were winners. The annualized return was a respectable 11.43%.

The 423,660 buy upside/sell upside trades from August 2, 1982 to the peak on March 20, 2000 netted 96.94 profitable trades. The annualized return was 12.68. The 131,703 buy upside/sell downside trades also did well; 92.48% were winners. The annualized return was 9.82%.

The buy downside/sell downside trades were losers. Of the 10,153 trades only 9.94% were winners and the annualized return was a 19.73 loss. Notice the SP500 downside was much worse than the DJIA downside. The SP500 has more technology stocks than the DJIA so they helped bring down the SP500 returns.

The technology-heavy Nasdaq had a spectacular price run up from the October 11, 1984 weekly value of 246.2 to the March 6, 2000 weekly peak of 5048.62. Then the Nasdaq collapsed.

For the 450,775 trades from October 1984 to December 2002, 91.58% were winners and the annualized gain was 12.82%.

The upside produced 323,610 weekly trades of which 94.55% were winners. The annualized gain was 15.09%. Buying and selling on the upside was an almost sure way to make money. The buy at any price mentality worked almost 95% the time because prices kept going up.

Buying on the upside and selling on the downside after the price peak made money 90.64% of the time. The annualized return for this trade type was 11.57%. Overall, investors made money buying the upside and selling the downside because the beginning and mid-term prices of the upside were so low compared with the downside prices. Also, the upside was much longer than the downside.

Buying the Downside was a Disaster

If you think the DJIA post peak downside was bad, look at the Nasdaq. From the March 6, 2000 peak to the December 23, 2002 weekly close there were 10,440 buy downside/sell downside trades and 90.04% were losers. The annualized loss was 43.79%.

It was almost impossible to make money in the post-bubble downside. There were periods of impressive temporary rebounds, but only 9.96% of the possible buy/sell combinations made money.

Nikkei 225 - A Very Long Downside
The Nikkei 225, the major index for the Japanese stock market, has been in a decline since it peaked in 1989.

From January 4, 1984 until December 23, 2002 only 37.83% of the 482,653 weekly trades have been winners. The annualized return for all trades was -1.27%.

The buy upside/sell upside trade type had 47,586 trades and 96.52% were winners. The annualized return was 24.08%. Buying and selling stock before the peak was very profitable. However, if investors missed selling before the peak, they had difficulty making money. There were 208,266 buy upside/sell downside trades and only 44.93% were winners. The annualized return was -1% for this trade type. Only 19.02% of the 226,801 downside trades were profitable. The annualized return was -6.83%. Like most long-term declines there were price rallies when money was made. But overall the returns were negative.

DJIA 1929 Crash - A Downside Catastrophe

The 1929 stock market crash is unique because of the magnitude of the losses. The crash sent prices from a weekly peak of 380.3 in August 28, 1929 to a weekly bottom of 41.6 on July 4, 1932.

The price series for the CTM analysis of the crash starts on October 1, 1928 and ends at the bottom price of 41.6. For this period only 11.81% of the trades were winners and the annualized return was -46.15%. This upside period was brief compared to the downside period so the return for the entire period was negative.

Investors who bought and sold before the peak made money. Of the 1,128 trades 88.03% were winners. The annualized return was a whopping 38.71%, which reflected the speculative nature of the pre-crash stock market.

Investors who bought the upside but missed selling before the peak did not fare well. Only 7.03% of the buy upside/sell downside trades made money and the annualized return was -31.91%. The price decline was so severe few investors dodged the bullet of plummeting prices.

Only 7.1% of the 11,026 buy downside/sell downside trades made money. The annualized loss of -64.06% spelled disaster for investors who mistakenly bought the downside. Recall the buy downside/sell downside annualized return for the post-2000 Nasdaq bubble was -43.97%.

Conclusions and Recommendations

The previous examples make is very clear that the upside is a winner's game and the downside is a loser's game.

Only Buy on the Upside

It seems so simple - only buy when prices are going up, but it's a difficult rule to follow. Because of people's compulsion to buy stocks, many investors buy on the downside thinking they are getting a bargain because the price declined significantly form a previous high. CTM shows the only way to have a high likelihood of making money is to buy on the upside. It's on the upside that the preponderance of price moves are up.

Never Buy on the Downside

The previous examples show, without question, the likelihood of making money is very low if you buy and sell stocks on the downside. Yes, if you successfully buy the dips, you can make money on short-term trades. But the number of opportunities for such trades is limited and you have to correctly identify the dips. Therefore, adopt the rule that you never buy on the downside.

During a prolonged decline in price, the overwhelming number of trades are losers making it very unlikely you can make money. Resist the temptation to buy on the downside because you think you're getting the stock at a bargain price. If you buy early on the downside, the stock will get a lot cheaper and your bargain won't look so attractive.

Also, don't buy a stock just because you think it can't go lower. Simple arithmetic shows that a $60 stock that is halved to $30 can get halved four more times before it is less than $1. Recall Lucent Technologies. Buying the downside is simply a guessing game. First, you don't know how long the downside will last. Second, you don't how low it will go. Finally, you don't know what the next upside will look like. If the next upside is sustained and moves higher, you win. If not, you lose. Read Buying on the Downside and Selling on the Next Upside to learn more about why this strategy is a real gamble.

Sell Quickly if You Bought on the Downside

Suppose your realize you just bought on the downside. What should you do? Because you paid too much, immediately sell the stock. We know the buy downside/sell downside is a losing game. Because you don't know the future pattern in a real-time situation, you don't know how large your losses could be so sell immediately. Take the profit or loss and preserve your capital. To avoid significant losses, you must have the discipline to take small losses. If you quickly cut your loss, you'll keep most of your money and have it available for the next investment opportunity