Tuesday, June 27, 2006

Investing Myth: Buy and Hold is the Best Investment Strategy

I am a contrarian. Since my goal is to have serious money and since most people are poor (see the Pareto rule), I want to avoid following the mistake of being conventional.

One of the most common conventions in investing is that you should "buy for the long term". Advocates of this position cite a few major reasons for doing so, namely, that you minimize taxes and transaction fees. Taxes and fees can indeed be large drains on investing portfolios. Warren Buffett, who is famous for saying that his favorite holding period is "forever", took substantial pains in his latest letter to shareholders (pg 17 "How to minimize investment returns") to explain how the financial services "seduced" Americans into trading assets, and paying for the privilege. In fact, Buffett, arguably the greatest investor of all time and one of the people whose approach to investing I study carefully, is often cited by the "buy and hold" crowd as proof that buy and hold is the best strategy.

Looking a little closer, however, we can see that, in fact, buy and hold, for all its apparent tax and transaction cost advantages has a great many weaknesses.

First, most retail (small) investors do so inside of tax-advantaged savings plans, where most of the tax advantages of holding are wasted. Since taxes on earnings are already deferred until withdrawal, what tax benefit does long-term holding really offer? In fact, if you are investing in a 401(k) or IRA that is not a Roth (e.g. traditional or SEP-IRA), even the benefit of lower capital gains and dividend tax rates is lost, since all withdrawals are taxed as ordinary income - the same tax rate that short-term traders pay on their gains. (Gains in a Roth are tax free, which is the main reason that the Roth is the best savings vehicle the US government ever devised, at least from a tax perspective).

What if you aren't investing in a tax-advantaged vehicle? Well, depending on what you are doing, you can often defer taxes indefinately through use of a 1031 exchange, which is a tool to help people swapping a piece of property for a "like-kind" property. This does not only apply to real-estate, it can also apply to business assets, though, unfortunately, not to common stocks, which nevertheless, qualify for beneficial tax treatment after only one year (cap gains), or even less (dividends requires 90 days). This hardly represents a "forever" holding period.

Second, buy and hold fails to protect you against downturns in the market. If you purchase the diversified mutual fund, and buy, hold and pray, you are exposed to significant amounts of market risk (which peversely has people worried about how "the market" is doing and not how their investments are doing). "The market" has historically had huge drawdowns, from which you have no protection. While the long, long-term trend in the market has been upward, you can find at least two occasions in the past 80 years where "the market" has failed to increase in value for decades. It took until 1954 for the Dow to surpass the high of 383 it set on September 3, 1929: 25 years, and again between 1964 and 1981 the Dow remained flat (with plenty of volatility). Sure, if you held, you got your dividends, so you got even before the Dow did, but what if you were forcibly "retired" in 1930 or 1973 due to the downturn and needed those assets to provide for your livelihood? Are you investing to be able to live off the dividends alone? Forced to sell in an unfavorable environment you could be wiped out before a market recovery.

In fact, no real investors have become rich by simply "buying and holding", not even Warren Buffett. When asked at an annual meeting of Berkshire if he agreed with Phil Fisher, Buffett admitted that when he was younger he would sell, when something better came along, but now that he had more money than ideas he stood pat.

This is a key insight: neither I nor you are Warren Buffett. An investing strategy for becoming wealthy is quite different from an investing strategy for when you are already wealthy. Why use the wrong one?

One of Buffett's main reasons for holding forever is the fact that with over $100 billion in assets, it is actually difficult to find investments that are both good and meaningful. In his case, the transaction costs involved in moving such large amounts of money in and out of securities would eat most of his additional gains (after all, he can seriously influence pricing of a stock). Unlike you or I, Buffett has another reason for sticking to his policy: it helps him purchase the businesses he wants.

Buffett looks to become a controlling shareholder of a business. One of the reasons that he can avoid overpaying, is that he offers something really unique among buyout firms: he allows management to retain control of the busienss after they sell it. If management suspected that Buffett would resell the business anytime a better investment came along, they would ask for much larger control premiums, because they would know that Berkshire might sell its stake to another, less management friendly, shareholder.

Again, if you aren't purchasing control, why would you assume that the best strategy is simply to copy what Buffett does now?

So, if buy and hold isn't such a clear-cut winner, why is it so often followed? I think the first reason is emotional. It feels good to think that you made a "good purchase" and then, like a favorite piece of furniture, or a home, stay with it for decades. Second, most of us are purchasers, not sellers. We are consumers first, we rarely go through the process of selling. We sell our labor, or our home, and the sales pitch is a stressful, once in awhile activity. Given our inexperience and our general inclination to shop, buying is simply our natural mode.

Contrast that with what rich people do. Rich people are selling all the time. They are selling securities (to the public), selling real estate (to emotionally charged homeonwers), even selling themseves (their latest book). Strategic investors know how they are getting out, before they get in. That is why they are investors (and strategic), not savers looking for a better savings account.

A much better strategy is to do what Buffett did on his way to becoming rich - analyze the value of your investment, and when it becomes fully or overvalued, sell. Set this price when you purchase the investment, so that you do not become emotionally attached. It is so easy to tell yourself that that winning investment has another point in it, and then watch it tumble.

Always be watching out for a better idea. Keep most of your money in your 1st and 2nd ideas. If you have lots and lots of ideas, either you have a very favorable market (possible), or have difficulty descriminating between ideas. Force yourself to narrow your focus and decide, even between good options.

Just remember, most of the people who are telling you that you need to buy (and right now!) are selling securities. If they represent such a great value, how come they are not suggesting to the people who are selling the securities that they should hold out for another day when prices are more favorable? Perhaps they are.


  1. How do you personally decide what price to sell a stock you own? And do you ever revise that target?

  2. I once read this line: "wealth is created by moving money from overvalued assets into undervalued assets". The NEED to move money in that sence, to really build wealth is what you HAVE to do. The trick is, to know what's overvaled and what's undervalued. Something every investor is always trying to figure out.

    Had you moved your money from tech in 99' and put it into energy stocks, that would have been a brillent move. To think, oil was $10 a barrel in 98'! That's undervalued.

    I shorted Toll Brothers for a client last August for 50 a share. We covered just 3 months later at 37. 10 months later, it's 26 a share! Sometimes, asset prices to to extremes, it's quite easy to know when something is very overvalued or very undervalued.

    It's the inbetween that's the hard part. Asset prices can just fluctuate unpredictably.

    I think that simply by buying assets only when they they are very depressed in price and selling when the get to middle ground of valuation is most prudent. Waiting to sell when it gets extremely overvalued.. is just hope.

    Buffett is my hero and his ideaolgy is timeless for sure. One of his quotes is simply "I'd rather be certain of a good investment than hopeful for a great one."

    Going back to the Toll Brothers trade.. we covered in 3 months for a 26% gain. A GOOD investment. Had we taken the chance and held for another 7 months, we'd have had a gain of almost 50%. A great investment.

    BUT, I believe that if you can do 10% more than the Dow Jones Industrial Average consistanly for more than 10 years, you'll go down in the history books.

    Jason Tillberg

  3. Great comments, Michael and Jason. The simple answer to the question is that I do a range of values, based discounted cashflow projections with several scenarios.

    If the business is large, like CL, I will often take each line of business, and project growth rates for each LOB in different regions, and say, well, oral care in Asia should grow between x and y, and do a revenue and gross margin calculation for each one. I add these projections to the other projections for other LOBs and other areas, and you begin to get a range of values, and a distribution of probabilities, which allows you to calc a standard deviation (if you want), or simply get a sense of realistic ranges.

    I generally find that stocks do in fact, enter this range, but that once they do, I sometimes get greedy, and "wish" for the stock to rise as high as my "optimistic" estimate, which rarely happens. Unfortunately, it then often falls back toward the lower end of the range. The faster the rise, the more often this happens.

    TRLG is an example. When I purchased at 13.50, I estimated the value at anywhere from $17-$27, with a most likely value around $24. It did in fact reach 24 and change, and on that day, I was thinking about selling. I was thinking very hard, but then I convinced myself that the busienss was so great that I had short changed it, and held it. It now trades in the mid-16s, though I still think it to be worth more.

    INTC is another example. Jason knows, I did a DCF model for the business when it was at $25 that projected values from anywhere between $17 and $34. This is a very wide range, and I thought the circumstances that would take it to $17 (which involved a margin and/or revenue collapse resulting in flat EPS over the next five years) to be remote. Sadly, my DCF models were better than my understanding of what was happening in the semiconductor space, and actually, my negative valuation was exactly right.

    So, I guess the answer is, yes, you have to change your price target, but only when something truly fundamental changes. Otherwise, stick to your points, and sell.