When it comes to buying stocks, there are basically two major philosophies on the best time to do so.
In the first camp, we have the much more popular and traditional belief that the best time to buy a stock is when it’s priced very low – well below its previous highs, in fact.
This is an easy-to-understand philosophy. If a stock had been trading at $100 and it’s now trading at $30, it must be a great bargain, right? We apply the same strategy to the way we buy most things in life. If a pair of jeans we want had previously been priced at $100 and now, during a big sale, they’re priced at $30, we buy them as fast as we can.
Value investing, value shopping; it’s based on the same basic premise.
Of course, there’s often an underlying reason that a product is on sale. Perhaps the jeans we’re interested in are priced 70% cheaper than before because they’ve been damaged in some way. Or, perhaps they’re simply less popular than they were before because a new line of better-quality jeans are hitting stores.
The same goes for stocks. A stock that is trading 70% below its previous high may not be much of a bargain if the company it represents has declined in quality and/or if its competitors are doing a better job.
This explanation falls on deaf ears for the majority of investors. It’s a visceral human reaction: we want great “deals” and we act fast when we see them.
Yet, there is a much less popular camp of investors who adhere to an opposite philosophy when it comes to buying stocks. Instead of seeking out “great bargains” at low, low prices, these investors look for stocks that are trading at or near their highest prices ever.
“Now why would anyone do that?” most investors ask.
It’s a good question as this concept goes against almost everything we’ve been told about being “smart” with our money and seeking out “value.”
When we apply this buy-at-new-highs concept to our shopping example, it makes even less logical sense.
If the jeans we wanted last week at $100 are now priced at $150, we get irritated. We shake our heads and wonder who in their right mind would pay this new price for jeans that cost 50% less just last week. We get angry at ourselves for not buying them at $100 last week, but we certainly don’t snatch the jeans up and buy them at this more expensive price.
In some cases, an increased price DOES cause us to buy quicker. Take the Real Estate boom from a few years ago as an example. When prices went up, people panicked and paid up for homes they didn’t want to miss out on.
But such cases are rare.
Our human minds, for the most part, seek out value and we know that buying into a price war is not smart.
For this reason, I’m always looking for ways to help traders realize how strategies like the Darvas System work, even though they seemingly go against logic at first glance. Buying at new highs just doesn’t sound “smart” to most of us.
Here’s an analogy that comes directly from Nicolas Darvas himself in explaining why we chose to buy at new highs. It comes from his second book, Wall Street: The Other Las Vegas.
“I determined that I would look at stocks as though they were horses in a race, and judge them on form,” Darvas wrote. “That meant automatically throwing out also-rans, even though they might have been front-runners at some earlier period, and concentrating on those few that were actually surpassing themselves, with no signs of flagging.”
Darvas continues with this horserace comparison: “This is how I figured it: A stock which was formerly a champion, selling at, say $150, may look like a bargain if it is currently on the market at $40 and gaining ground. But I also figured that it is coming from behind, and thus laboring at a terrific handicap. To have slipped back from $150 to $40 means to have inevitably inflicted serious losses on all the traders who bought it at or near the peak and were later forced to sell at lower prices. Thus, there is certain to be strong psychological resistance to overcome, much ground to regain, before such a stock will again begin to look like a winner.”
This is such a vital point made by Nicolas Darvas. As the $40 stock tries to come back, it’s going to face resistance with each step it tries to regain, especially as it nears old highs. There will be investors who bought it at $80, $90, $100, $110, etc., just waiting to sell it back at those prices if given the break-even opportunity.
“Viewed this way I felt that the stock that has lost ground is in exactly the same position as the champion who has fallen behind in a race,” Darvas continued. “Before he can begin to win, he must first make up the ground he has lost. Some entries may be able to come from behind. But in my mind, few race horses, or runners, and very few stocks, have enough ‘push’ in them to do it.”
Darvas wraps up this horse-racing analogy with the following: “I came to the conclusion that the only stocks which would be of real interest to me would be those that were breaking all previous records: stocks not merely rising in price, but actually in their highest boxes ever.”
In other words, the logic behind buying stocks as they break into new highs is a lot like picking a horse in the middle of a horse race.
Which horse is more likely to win, the one that has fallen behind in the race or the one that is right at the front?
The answer is obvious.
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