6 Reasons why Buy-and-Hold works.
Warren Buffett recently crowned to the richest man of the world, has a simple strategy he buys stocks of very conservative companies like Coka Cola, Gillette or American Express and never sells them again. But why is this such a good strategy here are 6 reasons which speak for it.
1. The markets are irrational and unforeseeable. Jeremy Siegel an economist of the Wharton School of Finance and author of “Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long Term Investment Strategies”, once assayed the 120 most volatile days in the history of the stock market. He came to the conclusion that just 30 days had reasons for this extreme swings. In other words 75 % of the biggest turnarounds in the history of the Wall Street had been completely irrational. So forget market-timing you are stupid if you try to suggest unforeseen events.
2. The more you trade,the less you earn. During the years of 1991 till 1997 Terry Odean and Brad Barber, both professors of behavioral theory of the University of California in Davis, investigated portfolios of 66.400 Merrill-Lynch-Investors. The professors concluded that there are two conclusive facts which cut down the profits of investors. The first are wrong decisions in stock picking and the second transactions charges. And look both facts were boasted by active traders so that they averagely earned 7 % less than the long term investors.
3. Odean and Barber also proved that investors who changed from offline- to online-trading lost more money. Before they were online they bashed the market with 2 %, however after they were online their earnings felled 3 % below the market. Isn´t this the best proof that more trading cuts down your profits? By the way Joe Ricketts the founder of Ameritrade one of the biggest online-broker once said: “The best thing an investor can do is to buy a good company and to hold it.
4. Investors buy to a high price and sell to a deep - and they loose at the high and in the deep. That´s true this is the conclusion of a morning-star-study. The most investors of investment-fonds have a very bad market-timing they buy in a high and sell in a low. The greed is at fold for this attitude because it causes a buy-hysteria and the most investors enter the market when it´s too late for it.
5. We are too confiding and loose. We deny and gloss over losses. Not a long time ago a study of the magazine Money was published which said that 88 % of all investors experience a phenomenon, which is named a propensity to optimism or an overreaching confidence by psychologists. For that reason we often make wrong investment decisions, take too much risk on us and loose and then we pretend that there is no problem. More than the half of the investors with an exaggerated opinion of themselves really believed they would beat the market but in reality they lay between 5 and 15 % below it.
6. Unfortunately even successful traders don´t earn very much. Many People believe professional trading is a way to get rich very fast. But is that really true? Definitely not that´s what many studies have proofed, professional trading requires a very high level of concentration when you what to trade for your job you have to give up your normal one.
Take advantage of what you already know
In my last article Do not trust analysts and fund managers, I pointed out how important it is to make own investment decisions. But how to find that perfect company? I think, most investors have yet made the mistake to buy a stock because it was hot or sounded exciting, like microchips in the New Economy boom, for example. But that is exactly what your fund manager picks on a regular base: companies that sound exciting and hopeful. Unfortunately, he is often wrong with his picks. So you have to rely upon yourself to find good stocks and guess what, you are in a far better position than any analyst.
The most important thing here is really never to buy stocks from companies you have absolutely no idea of the business model. It is also only a first step in the investment process, but a very basic one. So, instead of buying that microchip firm, take a look around you. Everyday you are surrounded by a lot of companies either at work or at home. Your credit card is probably the only requirement to become an shopping mall analyst. Take advantage of what you already know! If you work in the steel industry, for example, you know how to estimate the current situation of your industry and even know which companies perform well. You just have to put your eyes open and pay attention. You got better sources than any analyst and so you have the chance to discover excellent companies before Wall Street does.
I have got two examples for you, the first one is Wal-Mart. I am not from America, but you surely must have noticed, that this company was doing extremely well for years. The stocks performed great between 1975 and 2000, in fact the chart went up for 25 years! It’s amazing how much time people had to notice that amazing development. This happens all the time, because there are always good companies with great products around. Let us take a look at Apple, a typical turnaround. In 2002, when the stock sold for $12, you must have noticed the first people with this cool, white iPod music players on the streets. In December 2007, it sold for $200, what an investment! And again, you had really a lot of time to notice that Apple is doing something right. Everybody who bough an iPod at this time, should have bought shares too 
So, always ask yourself: What does the company do? I’m sure, you have specific knowledge of the industry you work in, so you know what is important to have success in this industry. Beginners often buy stocks in fast growing industries, because they think that there are no out-performer in industries with a low growth rate, but that is only true for cyclical industries. There are always great companies around and they are near you, you do not have to buy that hot Internet stock from China, just go to the local shopping mall or ask your children or some teenagers what stuff they bought the last 6 months. You will be surprised how many opportunities you will find.
Do not trust analysts and fund managers
People who are new to stocks often trust professional analysts and fund managers when it comes to their opinion about a certain stock. They think, that when fund manager Mr. X from “The X Superfond” buys the stock for his fund, it has to be a sure thing. Especially, if he talks about it publicly, you should be very careful, because that is the point when it gets dangerous. Let me explain a few things about funds to you, if you not already know the facts.
We as small investors are in a better position than we think. To buy a certain position takes weeks for a fund because they invest such large sums of money. That is a fact. Some funds have even such regulations, that they only can buy 10 stocks and every time they have to invest 1/10 of their fund. So if the market capitalization of a stock is 750 million dollar and the fund has to invest 50 million, you can be sure this will take some time. And what applies to buying also applies to selling. So if Mr. X says buy to us, he is almost possibly selling his position again.
One really annoying thing for fund managers is that they are measured by their performance. But not only once a year, but often even quarterly. We as long-term investor are OK with losses, because we know that the stock will be up in the next 18 months. But that is not enough for our fund manager. He hops from one hot stock to another praying for performance so he can keep his job. They are not interested in long-term performance, they are worried about the next 2 months when they have to show good results to their boss. They do not worry about the money, it is your money they spend, not theirs.
At last, funds have very strict regulations. Generally, funds are often to big to buy stocks from small companies with a small market capitalization. If they buy in, they would often simply double the stock. There are also regulations that for example a market capitalization below 500 million dollar is not allowed. Even if they would like to invest, they are just not allowed or much to big. Some restricted funds are also not allowed to buy foreign stocks or just invest in stocks listed in the S&P 500. But by this regulations they often miss great companies. That is also a reason why funds hardly ever outperform the market.
So grab your money and buy stocks yourself, you can do better than the professionals.
The Coffeehouse Portfolio
“The most of us don´t need professional planer. We actually don´t need a complete elaborated plan, conservative money management isn´t difficult. In order to be your own stock exchange guru, you just need an array of goals, a few easy financial Investment-opportunities, realistic expectations, a time-frame, which allows your investments to develop, and a good aligned polygraph which conserves you of falling for buy recommendations of bounders.”
Jane Bryant Quin, “Making the most of your Money”
In 1998 the former broker of the investment house Salomon Smith Barney, Bill Schultheis released a small book with the title “The Coffeehouse Investor”. The book was very easy to read but despite that it clearly explained the bases of successful investing.
Bill uses 3 simple principles to build up a successful Portfolio :
- Saving : Start as early as possible and save your money consistently.
- Diversification : Spread your risk by buying more than just one fond, stock or bond issue.
- Index : The only thing you have to achieve is being on average, and you are the winner.
The simple Coffeehouse Portfolio consists of a 60:40 mixture of stocks and bond issues. Whereby the bond issues stake clones a medium-term corporate bond Index and the stock stake in the same parts the S&P500,Large Value Index, Small Index, Small-Cap Value Index, MSCI EAFE International Index, and the REIT Index. In the bear market of 2000 and 2001 when the Dow felled at 12 %, the S&P at 20 and the NASDAQ lost whole 50 %. This simple portfolio had an average performance of 5,3 % per year.
Just Relax and it will work at best
Investigations resulted in the fact that the performance of the coffeehouse portfolio is at best when you never justify it. You can check that by yourself on Bill´s website. So you can beat the market while you relax in a coffeehouse, drink some coffee and the only thing you have to do is nothing.
The difference between investing and speculating
Do you know the difference between being an investor and a speculator? Most people think, that at the moment of buying a stock they are investors. But after selling in 3 months with a 25% loss they should know that they are not, they are simply bad speculators. In fact, we talk about two absolutely different styles, so different like the night and day, or the men versus women of the financial world. They also typically attract specific personality types to each financial strategy, so not everybody can become a perfect investor or a perfect speculator.
A speculator is somebody who practices financial speculation, which involves the buying, holding, selling, and short-selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives, or any valuable financial instrument to profit from fluctuations in its price as opposed to buying it for use or for income via methods such as dividends or interest. Speculators are willing to take large, but calculated risks in search of large rewards over a short time period. Benjamin Graham once described speculation as “a rat race of trying to get the highest possible return in the shortest period of time.” Graham strongly believed investing should be in securities where the principal investment was reasonably safe and there were “satisfactory” returns.
An investor on the other hand is any party that makes an investment, which regularly purchase equity or debt securities for financial gain in exchange for funding an expanding company. They also purchase real estate, currency, commodity derivatives, personal property, or other assets, always in hopes of achieving capital gain, not as a profession or for short-term income. An investor has a fundamental “buy and hold” approach and is interested in long-term investments that provide a steady source of passive income. Typically the investor is the “boring” guy, because he is not concerned about the daily movements of the market.
So, why is knowing whether you are an investor or a speculator so important? It is simple, because knowing if you are an investor or a speculator is essential for developing an matching investment strategy for you. Know Thyself! It is not recommended to mix this two types of money making, unless you are very skilled and experienced. You should know your own risk tolerance and it should play an important role in your investment planning. Upon other terms, your risk tolerance is defined by your financial situation, investment knowledge/experience and of course your age. Financial risk also strongly depends on your personality, so again it is very important to know yourself before investing your money.
Reduce your investment risk with the Cost-Average-Effect
The cost average effect benefit from falling markets.Image we got 5000 USD and we buy GM shares, we buy our stocks at the first red point of the chart above to the price of 37 USD per share. But our investment doesn´t act like we wish it would and finally we sell our stocks at the second red point to the price of 27 USD per share. Bad thing we realised a falling share price of 27 % which would be a loss of 1350 USD.
But there is also a way how to make 1000 USD profit which would be a stock market return of 20 %, with same same amount of money and the same chart. In order to achieve that we use the cost average effect so let me explain. We assume that we start to buy our shares at the first red point to the price of 37 USD per share. But this time we just buy 27,02 shares with the amount of 1000 USD. We always repeat that if the markets are falling and we believe that we have got a new depression. For this example I always bought shares with the worth of 1000 USD at the red marked points.
- 1000 / 37 USD = 27,02 Shares
- 1000 / 26 USD = 38,46 Shares
- 1000 / 21 USD = 47,61 Shares
- 1000 / 18 USD = 55,55 Shares
- 1000 / 19 USD = 52,63 Shares
So in March 2006 we got a total amount of 221.27 shares iand if we say we would sell them now at the green point for the price of 27 USD we got an amount of 5974,29 USD.
Sounds good but what´s the catch ? The problem is first of all that you also have to pay more charges for your trader when you trade more. The second thing is that you probably will be very sad when the quotation climbs up just after you bought your first tranche with the price of 37 USD, because you could have earned more. But conservative investors are definitely on the safe side with this principle because you can´t misdo much except you buy a company which crashes. Otherwise you can be happy if the stocks are getting cheaper, because you can afford more shares.
Do not listen to Mr. Market
Mr. Market is an invention of the famous investor Benjamin Graham, who was the first proponent of value investing. Graham used an imaginary investor called Mr. Market, a very obliging fellow who turns up every day willing to buy and sell any number of shares in any company. You as an investor can trade with Mr. Market or ignore him completely, he will not be offended and will be back the following day to quote another price. He represents the stock market and has some serious psychic problems. Often the price quoted by Mr. Market seems plausible, but most of the time it is ridiculous. Sometimes he is very depressed, everything goes downwards and and his prices are low. But then his mood changes and suddenly he gets very enthusiastic and everything is alright again, prices rise.
Markets are irrational
As pointed out in our article about Benjamin Graham’s margin of safety, markets are irrational. Wise investors take advantage of this fact. If Mr. Market’s price is unreasonably high, then wise investors have the opportunity to sell. On the other hand, if it is unreasonably low, then you have the opportunity to buy a good company for a cheap price. Wise investors should always know the real value of an investment. You should buy and sell accordingly and not allowing Mr. Market to make a fool of you by offering you wrong prices.
Trust Mr. Value and make own decisions
In contrast, there is also Mr. Value. This guy is quite boring most of the time. He is the one working hard on the fundamentals and improves his company’s value every day. Mr. Value represents the economy and he is the one who really built it. Listen to him, not to Mr. Market.
A lot of investors are under the influence of Mr. Market. They look up there stocks everyday, are shocked when the price goes 5% down and buy like crazy when prices went up for a few months. Do not listen to Mr. Market anymore and make your own decisions based on fundamentals and the real value of the investment.
Ben Graham’s Margin of safety
The genius investor Warren Buffett once called it “buying one dollar for 70 cent”, the Margin of safety which was developed by the brilliant man Benjamin Graham in 1934. The precept of the margin of safety is very logic and works as follows.
Most people believe that the stock markets are rational, so that the stock-rate always reflects the actual value of a company. But that´s not true , you can prove that very easily. We you look back to the big ups and downs in times of a market crash. It´s definitely not logical that a company looses 60 % of its value and wins 120 % back in a short period of 2 years while the earnings constantly grow by 5 %. So we can conclude that the markets are irrational because sometimes the people become too afraid and sell very cheap stocks and sometimes they are just too optimistic and buy too expensive stocks. It´s not very intelligent but most people like to follow the herd.
But now, let´s get back to the margin of safety. If you know that the stock markets are irrational then why don´t make profit of it? First you look for very unpopular “cheap” stocks, the market capitalisation has to be far below the intrinsic value. That could be companies in trouble, after they reported bad news or complete industries with problems.
Now you calculate the value of the company in order to do that you can use different methods. 1. The Earning-capacity value 2. The Net asset value 3. The liquidation value. So for example, if you calculated that the intrinsic value of a company has the value of 100 Million USD, but the market capitalisation just lies at 70 Million USD, you get a margin of safety of 30% or 30 Million USD. You buy this stock and when the market capitalisation achieves the intrinsic value again you sell it.
Note: The margin of safety has not to be exactly 30 percent, but the higher it is the safer is the investment.
Investment Research: What does the company do?
Investing is all about information and interpretation. There are people who will not agree with me, but there are certain information you have to know before investing. One of them is knowing exactly what the company you want to invest is doing. Do you know what your company actually is producing? What is the main product? How is the industry going? This are just a few questions you have to answer before actually buying in. Do not invest until you entirely understand the business model.
Surveys and personal experience show that especially beginners often do not completely know what their companies are doing. Research is essential for successful investing, unless you are damn lucky. Do not buy stocks, just because they are hot and showed a good performance last year. In most cases it is already to late to buy in. No, you need a different mindset. Always act, as if you would buy the whole company and would have to hold the stock for 20 years. Remember, by investing in a company you become the owner of a small part of the company. It is your company now. So, would you still invest in that little fancy technology start-up, you do not even know what it is producing, just because everybody is talking about it? Check out the business model first, than make your decision. This will preserve bad surprises.
Where to get information from? Surely not from the company’s homepage, because they will always tell you, that everything is going fine and they are producing the best product around. I thing, this applies to most companies, their homepages are simply not informative and objective enough. I would rather recommend you free finance sites like MSN Money or Yahoo! Finance where you find a lot of information about both, financials and a description of the business model. So, do your research well and invest only if you understand the company. If you are not sure, do not invest.
The Rule of 72: Knowing when your investment doubles
The Rule of 72 is an easy investing rule of thumb which tells you how long it will take to double your investment. It is very practicable to illustrate the effect of compound interest. The concept of compound interest is easy to understand and the Rule of 72 makes it very easy to calculate.
“Compound interest is the greatest mathematical discovery of all time.”
Albert Einstein
To use the Rule of 72, divide 72 by the interest rate of your investment. This will tell you how long it takes your money to double. For example, let us assume your growth rate is 8%, your calculation will look like this: 72/8 = 9 years.
| Rate of interest | Years to double |
|---|---|
| 1% | 72 |
| 2% | 36 |
| 3% | 24 |
| 4% | 18 |
| 5% | 14 |
| 6% | 12 |
| 7% | 10.3 |
| 8% | 9 |
| 9% | 8 |
| 10% | 7.2 |
| 11% | 6.5 |
| 12% | 6 |
| 13% | 5.5 |
| 14% | 5.1 |
| 15% | 4.8 |
You can do this with any percentage you want. I illustrated the basic calculations at the table on the left side for you. You see, even 1% difference can save you a lot of time to reach your goal. Compound interest is really one of the most fascinating phenomena of the financial world and you should definitely take advantage of it.
Please keep in mind that the results of the Rule of 72 are not exact but they very close, so for most cases it will be just fine. Normally, you also will not get a constant interest rate, especially if you invest in stocks or similar investment forms. Important variables like taxes and inflation are also not included in the Rule of 72. However, this rule should enable you to quickly calculate the growth of your investment without using a calculator.
Never forget, time can be on your side, or not. So invest early in long-term investments, because the sooner you start, the more money you will have.
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