Suppose a business man can sell some product for a dollar. Since the product is in high demand, it costs the businessman 97 cents to buy it to sell. The profit will be 3 cents per sale.
Now suppose the product is very faddish and demand for the product could change quickly. He has bought a significant amount of the product for 97 cents in anticipation of lots of sales at one dollar. Furthermore, he hopes his sales price will rise to $1.06. He is anticipating his profit increasing from 3 cents to 9 cents, which triples his returns.
If suddenly the demand changes for the product and his sales price goes down to 80 cents, he is facing a loss of 17 cents on each sale - a big bath! If it is his sole product, he may be putting his business at risk.
Now if he bought the product he is selling for 75 cents instead of 97 cents, he can still sell at 80 cents and make a 5 cent profit. Should he sell the product at one dollar, he has made a fantastic rate of return. He bought his inventory when no one else really saw the value in selling the product, so he got a great deal.
The above could be equated with the equity markets. Establishing a position in a security when prices are high, may provide a good return, but if the market changes for the worse, the results could be very painful. Stated another way, the upside potential is much smaller than the downside risk.
Judging the market is not a mathematical process since it ebbs and flows as the result of humans who make up the market. While there are many formulas and ways to mathematically measure risk, those formulas rely on stability of their base numbers. Human interactions don't have the same consistent attributes of the physical sciences. Therefore, mathematical formulas put on human interactions can and do suddenly veer off course at times.
The judgement of whether a market is high or low is always a difficult estimate to make, but clearly and realistically understanding the pluses and minuses of market movements is essential to being successful.
Assessing the market as being "relatively high" or "relatively low" is a great way to frame purchase or sales decisions.
Don't "Just Do It"! Think before you jump. Buffett always says "I don't look to jump over 7-foot bars: I look around for 1-foot bars that I can step over."
