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Bye-Bye Buy & Hold? A 'Mad' World
Posted by: The Science of Hitting (IP Logged)
Date: February 3, 2013 12:15PM
There’s a myth in the investment community – knowing a little bit about everything is an impressive feat. The thinking is simple: If you’re at a dinner party and the person you’re talking to knows something about every company you mention, he must be one smart cookie.
From my perspective, this is hardly something that screams “successful investor.” To make it simple, let’s put a name to this – I prefer “Jim Cramer Syndrome” (JCS). Cramer is well known for “the lightening round”, where callers mention a company and he instantly gives his professional recommendation about the stock’s future prospects (the time frame for that recommendation is a bit less clear…); the fact that he can remember the names, basic profiles and headline facts (P/E, etc.), for hundreds of companies, is quite a feat; unfortunately, it has nothing to do with being a good investor.
While impressive, JCS has a major fault – knowing a little bit about everything is nowhere near as beneficial as knowing everything (meaning any pertinent publicly available information) about a handful of companies (say, a single sector). The reason’s pretty obvious: As a whole, the market is pretty efficient; if and when inefficiencies do pop up, there’s generally a good reason. It could be due to something superficial, like removal from a major market index causing forced selling, or it could be that something beyond common knowledge (possibly buried deep in the 10-K) has been overlooked by the financial community. Scratching the surface won’t help here – you need to dig deep and get your hands dirty to single out these opportunities.
Not only is it less beneficial – but JCS can quickly become outright dangerous. This syndrome has the undesirable side effect of causing overconfidence; when you start become known as the guy who knows it all, you want to live up to that honorable title – and suddenly start wading into the unknowable without any reservation (like our analyst friends who spend their time trying to outguess each other on quarterly earnings, then outguess each other on market reaction to those earnings, and so on - succinctly called a “Keynesian Beauty Contest”).
You don’t have to look far to find an example of Cramer stretching himself a bit thin – here’s one from last night (Feb. 1):
“The idea that you buy and hold through the best of times and the worst of times, by the way, that hasn’t borne out. It’s just not true no matter how many times you’ve read it or been indoctrinated by it. It’s not empirical.”
Of course, Cramer doesn’t provide any empirical evidence to make a case otherwise (it’s not even very clear what we’re comparing buy and hold to). Still, let’s take a look at two options:
Buying through the best and worst of times appears to have done quite well over long periods of time – as the history of the S&P 500 and DJIA show quite clearly; the result for an investor without any particular insight (also known as “Mad Money’s #1 Fan”) who indiscriminately purchases an index will, over time, generate returns in line with the market – as they should.
Here’s the other alternative, for our same individual who has no particular insight into any set of companies, as preached by Cramer: Buy and sell frequently (maximizing the amount paid in taxes and commissions) across any and every industry, and hope that you get lucky more often than you get slaughtered. The choice, at least from my perspective, seems to be quite easy. Cramer sees it a bit differently (of course he doesn’t have to pay the taxes or the commissions, so maybe that’s why he isn’t too concerned about their impact on after-tax returns.
Luckily, there’s a simple solution to JCS – focus on your core competencies and advantages over other market participants, and add a heavy dose of humility (use that “too hard” pile liberally). Rather than proclaiming to know everything, come to the table assuming you know nothing – and demand clear and thorough analysis when you think you’ve found something. A core competency that all individual investors should seek to develop is a long-term mindset: This is, without question, one of the single greatest advantages you hold over the institutional investor (as well as over individuals engaged in day trading and other nonsense). Ironically, this view is best explained from the words of a professional money manager (granted, he’s quite different from his brethren) – David Rolfe of Wedgewood Partners. He said the following in a 2003 letter to clients when discussing Wedgewood’s approach and how it relates to another attractive alternative for some clients – index funds:
“To outperform our peers we believe that we must emulate the most powerful attributes of index investing. By definition, index investing is buy and hold investing. This leads us to our history of minimum turnover of our portfolios. As a corollary, this also affects our stock selection. If we expect to invest in companies for many years we must then focus on those select companies with the brightest multi-year prospects for growth.”
(NOTE - I would highly recommend reading Wedgewood’s posted letters going back more than a decade (here). The letters clearly lay out the firm’s approach to avoiding the path of the herd and offering value to clients – an approach that has led them to outpace the S&P 500 by more than 5% per annum over the past fifteen years.)
Understanding the benefits of indexing is critical – and leads you down a path to think like an owner while emphasizing minimum churn (think of Buffett’s punch card). It requires specialized knowledge about individual companies – and generally, concentration in a handful of names (on any given night, Cramer likely recommends more companies than a firm like Wedgewood holds in their entire portfolio). Over time, the benefits of retained earnings and compounding, as well as the avoidance of taxes and trading costs, put the intelligent investor in position to put up some solid long-term numbers.
Traders approach the markets from a completely different perspective; each day, week, or month is an opportunity to trade pieces of paper with the hope of squeezing out a small win over the index. A great business getting cheaper is simply seen as a loser to be dumped, and the market is the ultimate source of knowledge in the form of daily stock quotes.
This approach is predicated on willfully ignoring logical behavior, in what is likely the most competitive financial endeavor in the world (not surprisingly, there’s a lot of interest in quickly making boatloads of money).
I look at such a game, and consider it a coin flip at best (and considerably lower for any individual); if saving for your retirement looks a lot more like gambling than investing, you might want to consider abandoning the world of “Mad Money.” In the world of investing, knowing a bit about everything in an attempt to outperform the markets is a fool’s errand; wading deep into uncharted waters is a much brighter path to investment success.
Stocks Discussed: SPY, DJI, QQQ,