Don’t be the Last One Into or Out of the Pool
A free market is a funny beast. Prices tend to go through cycles. On average, prices are accurate, but at certain points things get priced either way too high, or way too low. I think the reason for this is people tend to have a very short view when estimating where things will go from here. And knowing how much something will be worth in the future is important when you are figuring out how much to pay for something.
Consider a stock that will grow 20% a year for the next 5 years. You are going to pay much more for that stock than one that will increase 5% a year. The same thing with a house. A house that is rapidly increasing in value is worth more than one that is not. Unfortunately, one can never really figure out what is going to happen in the future. So what people do is look to the past for a prediction. The problem comes in that we tend to only look at the last year or so, sometimes at the last 2 or 3 years. When you have an item that runs in cycles this short term view can give you a very bad picture.
Let’s assume that the price of a stock is a wave as shown above. If you use a straight line price assumption based on recent information you’ll get very different results based on where you are on this curve, as show by lines A, B, and C. The most accurate number is Point C which is a close approximation of the actual average price increase over time. But if you purchase at point C, you’re going to have to hold for a long time until the next peak to get that return. If you end up having to sell at the low point between A and C you could lose a lost of money.
The best returns will be between the valley and the next peak where the rate of return could be two or three times as much as the average. The trick, of course, is that you never really know where you are on this curve, and the time between peaks can be 10, 20, or even 30 years. For most of us taking the long view can be difficult. There is also no guarentee that for any individual stock that the average slope is actually positive, nor that the curve will be this smooth, look at the price graph for any stock and you will see lots of bumps in it.
But you can see that purchasing right at the peak can be hazardous to your financial health, as it might be a long time before the price actually goes up again. Before you get into a market where prices have been rising for some time, think about where you might be on the long term price cycle. You don’t want to buy at point C.
It’s now clear that all those people who got into the stock market in 2000 got in at the local maxium. It sure seems to me that we are getting very close to the local maximum for most housing markets in this country. I’m betting that the stock market which is still pretty much out of favor is getting closer to a local minimum and that soon we’ll see the outsized returns there as people reaslize what is happening in Real Estate and start looking for better returns elsewhere.