Buy Into Weakness – Investment Rule #1

In Financial Markets, Investing, New Rules, Options, Words To Live By by Gen Y Finance Guy24 Comments

Reading Time: 5 minutes

Over the course of the coming weeks and months I will be laying out the investment rules that I live and die by. These are rules that I have developed over the last ten years as both a retail and professional investor and trader:

Rule # 1: Buy into weakness.

Rule #2: Sell into strength.

Rule #3: Reduce cost basis.

Rule #4: Keep investments small.

Rule #5: Keep 80% of total invested capital in ETF’s and up to 20% in individual names.

Rule #6: Choose duration over direction.

Rule #7: Manage your winners.

Rule #8: Manage risk at order entry.

Rule #9: Increase your # of occurrences.

Rule #10: Make investments with a probability of profit > than 50%.

(Note: I will come back to this post and create hyperlinks as I cover the different rules in future posts, however I would highly recommend that you join the email list in order to receive new posts delivered right to your inbox. I don’t want you to miss this).

One thing that you will learn over this series of posts is that I love to trade options. More specifically I love to sell option premium. My overall goal after I cover all 10 of my rules to investing and trading the financial markets is to show you how you can reduce your risk, increase your probability of profit, and give yourself more than one way to win. Too many people out there have bought into the notion that options are too risky and that they are too advanced for most investors. The truth is that risk is a function of education, and I want to educate you and show you how options can play a vital role in your portfolio. I am actually going to teach you how options can reduce your risk (by reducing your cost basis) and give you an edge in a market where most retail investors have none.

Let’s first cover the first rule.

Rule 1

Rule #1: Buy into weakness (i.e. get long)

This simple rule says that we buy investments in equities on days when they are down in price. And if you were selling an investment, you would sell into strength (rule #2, but we will cover that in the next post of the series).

For most people who have ever made an investment or trade in the financial markets, buying into weakness appears to be a huge mistake and can even be scary. What if it keeps going lower? That doesn’t seem to stop people from holding onto investments that once were headed higher anyways…

The herd mentality is that you buy into strength, which typically leaves retail investors regretting ever getting into the market at all. The average investor buys the top and sells the bottom (it’s sad but true). That’s because humans are not innately wired to invest. You have no edge in the market if you just do what the average person does. And no one reading this wants to be average right???

I am about to pose some very contrarian views on how and when to get long equities, or any asset class for that matter. I will forewarn you that these views will go against all conventional wisdom you hold to be true.

3 Universal Truths That Don’t Get Talked About Much

  1. There is only one way to win (make money) when you buy an equity (assuming no dividend of course). You only make money when an equity increases in price.
  2. An equity has 2 directions it can move: Up or Down. Of course when the market is closed it doesn’t move at all.
  3. The direction of a stock has a 50% chance of going up and a 50% chance of going down on any given day, week, month, or year. Although due to a log normal distribution, the markets typically go up over time. I think something like 70% +.

So the question we need to answer is what can we do to gain an edge and thus increase our probability of a profitable investment? Because let’s be honest with ourselves, there is no such thing as a guarantee.

The simple answer that is probably a lot easier said than done is to “buy low and sell high.” If you haven’t heard this mantra, you have probably been stuck between a rock and a hard place up until you found this blog. The reason this is so hard to do is due to the natural apprehension to buy stocks when they have decreased in value.  The stupid money (being the average investor), has this ridiculous idea that stocks that are going up will go up forever and stocks that are declining are likely going to zero.

Ok, so maybe that is extreme. But I am sure you can partly relate to that. This is the kind of thinking that drives the whole fear and greed cycle.

I strongly urge you to get over your apprehension to buy into weakness (i.e. when a stock is down in price). This is one way to reduce your cost basis and increase the probability of profit (in a future post we will talk about other ways to reduce cost basis even further). This is not the same as timing the market, instead you are patiently waiting for more favorable prices. And as we get deeper into this series you come to realize that down days are the best days to sell option premium…but let’s not get ahead of ourselves.

Think of it this way:

Warning: This is a very extreme and simplistic example to more clearly illustrate my point.

Example 1 – Your friend buys Apple stock as it is making all-time highs around $750/share (pre-split). The media and Wall Street have been hyping this stock to be the first trillion-dollar company. He just couldn’t miss out and had to buy before it was too late and he missed the move.

Example 2 – You are interested in the stock but unlike your friend, you want some margin of safety (something Warren Buffet looks for in all his investments) that will increase your probability of profit (or at the very least reduce your downside risk, because all investments have downside risk). So you decide to wait for a pull-back. Apple disappoints on earnings and over the course of the next 15 days the stock declines 20%. With the stock now trading down $150 from its all-time high of $750, you buy Apple stock at $600/share.

Who has a better chance of making a profit? You or your friend?

YOU DO!!!

Your friend needs Apple to rise in price by 25% just to get back to even after losing $15,000 for every 100 shares of stock. If it rises 25% from your purchase price, well you make 25%.

The Takeaway Lesson

The person with the lowest cost basis always has a higher probability of making a profit on an investment. It is simple math. The lower your cost basis, the lower an asset has to move in order for you to make money.

Now obviously you still want to make sure the companies that you are making investments in are solid companies. Sometimes companies are cheap for a reason (that’s why you always do your homework). This is also why I use ETF’s in 80% of my investment activities in the stock market (will cover this in a future post as well). All that I will say now is that ETF’s remove the binary risk you get from individual stocks from things like earnings announcements, take overs, CEO scandals, etc.

– Gen Y Finance Guy



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Comments

  1. Buying into weakness is a clever and perfect way to put it. In fact, this is why dips in the stock market are actually advantageous to the majority of Americans who routinely and consistently invest. While it seems like dips in the market cut away at some of your investment’s earnings (and temporarily, they do), it also gives people the opportunity to invest into cheaper stocks that will, as history has clearly proven, increase in value.

    That’s why the stock market is an investment medium for the long term. Day trading is a bunch of bull. Stay consistent in the market. Don’t check our stocks every day and get stressed out over them. Dips happen. Spikes happen. In the end, almost everyone will make cash in the market if they resist the temptation to over-manage their portfolio.

    1. Author

      Yes buying dips is another way to put it. And because timing the market is virtually impossible because no one ever know what it will do from one day to the next, dollar cost averaging is a great way to scale into a position. As you mention Steve, this is done by investing routinely and consistently overtime.

      Markets do have an upward bias. In theory they can go up forever, but can only go to zero, thus the log normal distribution.

      Cheers!

  2. ugg.. what a silly time wasting post.. not visiting again.. bad advice and extreme / exaggerated examples.

    1. Author

      Hi Joe,

      Sorry to hear that you think this post was a waste of time. You have likely not subscribed to the comments since you have no intention of coming back. However, I thought I would try to reach out nonetheless to get more specific feedback if you were willing to add some color around your comment.

      What makes this bad advice?

      Yes the example may have been an extreme and very simplistic, but was intended as such to illustrate the point.

      Is it bad advice when you tell someone to go to Amazon to buy X-product because it is 10% cheaper than at Target? I don’t think the person who just saved 10% would think so. I know I wouldn’t.

      The point is that prices fluctuates and there are guaranteed to be down days, so why buy something that is $100 today when tomorrow it could be $98. Yes it takes patience, and it goes against conventional wisdom. Maybe its my fault for not providing the other components about the increase in option premium do to fear leading to increase volatility. This allows you to sell calls against your stock position at inflated premium levels. Or maybe a synthetic long like selling puts may suit your fancy.

      I hope you come back and expand on your comment. As the last time I want to do is write posts that waste peoples time.

      Cheers!

      1. No need to feed the trolls, GYFG.

        Take a look at how many people panic sell during downturns and actually realize the losses before the market rebounds and ends up even higher than before. People are strange and let fear influence them into to doing dumb things.

        Hopefully this type of advice can reach someone who genuinely didn’t know – and when the next downturn comes, they BUY instead of sell. That is who you should be writing to…not this anonymous chump who doesn’t have the courage to sign his work.

        1. Author

          Yes Brian your are right. I contemplated whether I would even approve the comment. But I decided I will only filter out spam, I don’t expect everyone to agree with me. But my hope is that in the future people will defend their position. I am willing to even reconsider my position if someone presents an intelligent and compelling argument.

          I also realize that there is more than one way accomplish the same goal.

          1. It’s the ugly part of blogging, when you get negative comments that don’t even give arguments. I’m always hoping for a civil dialogue, but unfortunately, sometimes you’ll get comments like this or worse. I think people need to understand that these are PERSONAL finance blogs, which means we give advice based on our experience, not one-fits-all. Your advice will be different from mine, and that’s why we’re documenting our journeys, people can read and form their own opinions.

          2. Author

            Your so right Felix! I will never give any advice or recommendation on something I don’t actually do myself.

            But it doesn’t mean it is for everyone. Like you, I want to have an open dialogue.

  3. I am looking forward to the next blog posts about how to implement all this. I am a total newbie to options. I personally been dollar cost averaging the last ten years of my investing life. I am 90% index funds with Vanguard, and own two individual stocks. I like the passive approach, I have gave up on trying to beat the market. The average investor the odds are just simply stacked against us. But every little bit helps, and always willing to learn. I am a regular reader over at financial samurai, I came across your guest post there, and here I am. I enjoyed your guest post and your story. Keep up the good work!

    1. Author

      Thanks for stopping by Patel. Sam puts out some great content over at Financial Samurai.

      Options are not nearly has complicated as the mass media makes them out to be, nor are they as risky. They can be risky if you use them to “gamble”. It will be fun to great to get all 10 of these foundation posts out so that I can lay the ground work and pull it all together so guys like you can implement it into their own portfolio. No reason the odds should be stacked against you…I am literally going to show you how to put the odds in your favor.

      Look forward to seeing you around the blog.

      Cheers!

  4. When we first started aggressively trying to save money for investments and actively watching our balances, we agreed that the very best approach was to use total market index funds from Vanguard. We don’t have the time, education, or desire to do the research required for much of anything else. And then, oil prices plummeted. For several weeks we tossed around topics about how we should buy into oil since it was so low right now. Eventually the idea took hold, and we bought a chunk of the energy ETF from Vanguard. But we are still very much newbies to the investing world. I’m eager to learn more in the rest of the series!

    1. Author

      Hi Mrs. Maroon,

      It sounds like you are evolving a bit on your approach to saving and investing. I personally think that self-directed investing is the way to go and its never been easier with the technology and education that is available.

      My goal is to convert nice folks like you into self-directed active participants in their own investments. It doesn’t take nearly as much time as most people think, as for the education. I think you will feel a lot more comfortable once I get these 10 rules out and am able to bring it all together.

      BTW, Great job on recognizing an awesome opportunity to buy into weakness in the oil sector. That is the perfect example of buying into weakness. These types of opportunities come around a lot more often then people would think. And ETF’s are probably the best way to invest here. I personally invested in these oil ETF’s once oil broke below $50/bbl: OIH, USO, and EOP.

      Looking forward to seeing you around here more often.

      Cheers!

  5. I’ve never traded options. I like keeping an eye on the market and buying when the stocks I’m watching are down. I bought Apple all the way down to the bottom last year, and sold when iPhone 6 came out, making a nice few thousand dollars in the process, enough to pay for 2 Macs and an iPhone 6 lol 🙂 Bought Monster when somebody was suing and stock was down, bought Amazon when the war in Syria broke and everything was down, bought Starbucks when I read that coffee producers had an extremely good year and coffee prices were down. Everything I ever bought was speculation, and short term for a quick profit. I love the game and hope to have money to start playing again soon. I would like to learn more about options, ETFs, index funds and others, I’m pretty simplistic and straight-forward in my approach to buying stocks.

    1. Author

      Hey Felix,

      You have come to the right place. Because when this series is done I am going to walk everyone through how to successfully use options to increase their probability of success, reduce cost basis, and have more than one way to profit from investments.

      Stay tuned!

  6. I just bought VEUSX. Weakness most definitely. I think Europe and Int’l is a good long term buying opportunity right now.

  7. Great post. I’m more interested in learning about options and investing. Can you refer me to some good resources? Investing is the key to financial freedom and independence. That’s why the media, including the public school system, don’t teach it so you can stay in the rat race and take care of the poor by paying high taxes.

  8. Author

    Thanks Lootpost. Once I lay down the investment framework I plan to get much deeper in using options to invest and how they can/should play a vital role in anyone’s portfolio.

    Also plan to demystify the complexity of options and the risk associated with them. Of course if you use them the wrong way they can be risky, but just like if you over leverage yourself in a real estate investment that can be very risky as well.

    Buying options in a low probability game. The money is in selling options, but in the right way. I plan to teach how to sell options to reduce cost basis. In other words how options can allow you to buy a stock for cheaper than where its currently trading.

    But if you can’t wait, I would highly recommend that you go and check out TastyTrade.com, it is hands down the best source of education for options trading on the web and its FREE.

    In particular if you are just starting out I would recommend you check out the show “Where do I start”.

  9. Hi GYFG. I’m interested how you approach this situation with lump sums to invest in index funds like VTI. There is some talk over at Bogleheads.org that lump sums vs dollar cost averaging, and that just sticking the lump sum in all at once is the way to go. But I’m thinking if people want to drop a lump sum into VTI, and they’re in no rush, they just wait for a bear market?

    1. Author

      Hey Simon,

      I am not a big fan of lump sum investing regardless of if it is an ETF or stock. Well at least not in the context of a 6+ year bull run and record all-time highs. To me investing a lump sum is just setting yourself up for pain.

      In my opinion, the risk/reward favors the downside, but the problem is no one including myself knows when the market will finally turn from bull to bear. The longest run we have had before entering a recession is 10 years, so it could still be a few years away.

      The last thing I would want to do is buy the top with a lump sum and then have to wait 5 years to get back to even before I start making money. Especially when we know that stocks are cyclical and that we have boom and bust cycles.

      I am a bit of a contrarian when it comes to this. I have always believed that you should have some money available for market dips and correction, regardless of the opportunity cost of holding that cash.

      If we were at an extreme low to the downside instead of an extreme high to the upside I would be a fan of lump sum investing.

      But given the market I would be dollar cost averaging. I heard a new term last weak that expands on dollar cost averaging. It is called value cost averaging, like DCA but with a twist. You by more when the market is down and less when its up. It is obviously a more active strategy then a set it and forget it.

      And in full transparency I am holding about 50% of my portfolio in cash. Waiting for better prices.

      1. Hey GYFY,

        +1 on the DCA. While I agree to an extent, I hold far less cash in reserve for corrections. I have been burned by trying to catch falling knives (timing the market) and have embraced the strategy of putting more in the market every month. When it corrects, the contributions will increase and the reserves will come into play – but it could be years of a run up before that happens. It could be weeks.

        As always, awesome discussions ’round here.

        1. Author

          Yes, trying to time the market is like trying to catch a falling knife.

          My strategy is much more complicated than holding 50% cash. But with that said I would not recommend this to everyone.

          But as you point out, I could be subjecting myself to very meager gains, should the market continue to defy gravity. But I also remember the bottom of the market in early 2009.

          The markets fall much faster than they rise. There is a old adage that says the markets take the stairs up and fall off a cliff on the way down.

          I have only reduced my exposure, not eliminated it entirely. So if the market were to run up 15% this year, I would only capture about half of that. Which I am okay with considering there could be an opportunity to buy 20-40% lower based on typical market corrections during a recession/bear market.

          Thanks for stopping by.

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