Why It’s Difficult to Catch the Top or Bottom when Investing

If there’s one thing for sure about the stock market it’s that there are super smart people out there investing and trading the markets.  Brilliant people. People with high IQ’s and excellent investing senses. Today, many smart institutional investor’s have realized the power of using computers to execute their trades using software programs and algorithms they have developed that eliminate the emotional aspect of executing orders in the market.  Unless you’re a computer it is impossible to compete with another computer. This financial horsepower and their computerized systems can execute orders of large amounts of shares in a single stock in a timely manner. Their actions can trigger other computerized programs, so for an individual investor trying to watch the market and make decisions based on what they see is a huge challenge when the market or stock’s price starts moving fast.    

The average individual investor shouldn’t be trying to find the top or bottom in a market ever.  It’s a losing proposition. Institutions move stocks, and they move too quickly. The average investor is too small to move much of anything.  Most stocks trade hundreds of thousands of shares daily, so the order sizes have to be very large in order to make a dent in the actual trading price of a stock.  So the average investor has to see the top or bottom of the market’s move in order to believe it is the top or bottom, and by the time they realize what they have seen it is too late.

When an order to buy or sell stock is placed there are always two parties involved in a transaction in the form or a buyer and seller.  I think a lot of people today forget this because they place the order through their online broker and don’t see the actual party on the other side of their trade that occurs.  Institutions that place large share orders need someone on the other side of their orders for the order to execute. Because an institution’s order is so large they usually have to do opposite of what everyone else is doing in order to get their orders filled.  In other words institutions usually are buying when the market is selling, or the institutions are selling when the market is buying. When the pace of the market drop is swift that’s when the institutions are on the same side as the regular investors. No one wants to take the other side of the institution’s large order, since they see trouble also, so the market price will drop until someone thinks it’s a good price to take the other side of the order.  The same holds true on large fast upward moves. 

Years ago I learned that the best traders don’t look for a bottom or a top to a market.  They nibble on the way down and peel on the way up. There’s a saying in the industry that you don’t want to try and catch a falling knife.  Catching a falling stock is like trying to catch a falling knife. If you’re wrong it can be dangerous. The opposite of this is saying is that no one ever got hurt taking a profit.  Quitting before you reach the top prevents the bottom from falling out. For the average investor, nibbling on the way down and getting out on the way up is difficult and requires strong emotional experience and discipline due all the emotional biases that exist. These skills take learning, but keep in mind just because you have an education you still will have to learn how to stomach it.  

This is why the most savvy investors use the investment’s inherent value in some manner to determine they’re strategy.  They get in when it’s a fair price to do so, and they exit when they feel the investment has achieved it’s complete value.  This way of operating takes the market and institutions out of what they are doing, since the institutions actions have no bearing on the investor’s decisions.  This doesn’t mean the market won’t sell off and the strategy may have a poor return for a time, but generally these types of investment strategies have long term timing or a method of readjusting the portfolio at a specific time that is a part of the plan to get through tough spots.