In mid-March of 2009 I happened to be with a group of strangers when one of them recognized me and asked me what they should do with their money now. This happens about once a week it seems and always makes me uncomfortable. I never know how to answer these questions especially when I don’t know the individual’s situation or frame of mind. On this particular day I tried a different approach to answering the question. I have tried many approaches over the years and my objective is always the same. I want to convey that there is no right answer in general but that there are a number of right answers specifically. I asked the gentleman to try an experiment. I would ask him a series of questions and he would respond.
My first question was, “How do you think you should invest now?” He responded with the typical situational response that reflects the sentiment of the times. In this case, mid-March 2009, public sentiment was long-term bearish but short-term bullish since we were witnessing a strong short-term rally in the stock market after a long and deep drop. I then asked him a second question. It was, “Ok, I understand how you think you should invest now. But what about now?” I could tell from the look on his face that he was confused. I asked him a third question. I asked, “How about now? And now? How about tomorrow? Or the day after tomorrow, or yesterday?” My message was starting to crystallize. When it comes to investing. Now is always. Today is everyday. Investing is a continuum of decisions and if you don’t have a methodology to make these decisions you will not succeed.
This is why I am so insistent that anyone who invests must develop anthat both suits your personality and can be applied in a disciplined manner. If you can’t then you must hire an advisor with a proven approach. If you can’t develop one or can’t hire an advisor with one then you must instead simply avoid investing in the stock market. There is no point in investing in the stock market and trying to get 9-12% per year when you will fail. It is better to stay conservative and invest in intermediate term bonds and make a consistent 5% per year than delve in stocks in a haphazard manner.
There were a few other fellows in the room and one of them chimes in, “I am a Buy and Hold investor, what do you think of that?” I told him that there was no such thing as buy and hold. I explained that even those that preach buy and hold don’t practice what they preach. I cited the annual portfolio turnover rate, how often a portfolio buys and sells stocks in a given year, for a number of well-known buy and holders. I even explained that if you examine indices, the theoretical most extreme cases of buy and hold, you observe considerable turnover. I explained how the Dow Industrial only has 30 stocks in it and 10 of them weren’t included as of a few years ago and that only General Electric remains from the original Dow My point is that even indices have considerable annual turnover and that buy and hold is conceptual but not real and that when practiced correctly it is at best a “ approach to investing and not “buy and hold.”
At this point a third fellow chimes in. “Ok so today is everyday. I get it. Buy and hold doesn’t exist. I get it. The best investors in the world as well as index funds buy and mold their portfolios. I get it. But how do I mold my portfolio today?” This fellow was very clever and I give him credit for listening so I gave him my best metaphysical answer. I said, “You mold your portfolio the same way you always do.”
By this time I think it was clear that I wasn’t going to give anyone a simple answer. I could tell them all that I had the bulk of my investments on the sidelines awaiting a better entry point into the stock market. I could tell them that I had missed a considerable part of the stock market decline but that the price I pay for protecting my capital during bad periods is that I forfeit some capital appreciation during good periods. I could tell them that I was a rules based investor that was always invested in the stock market when it met certain criteria and that at other times I was materially out. I could tell them that buy and hold as practiced by most unsuccessful investors is actually “buy and fold” when things get bad or “buy and pray” it comes back. I could have done this but I’ve learned to not dispense advice that people can’t consistently follow. I’ve even learned that even if I tell people my exact rules of investing that they don’t replicate what I do. What I have learned is that people can develop their own methodologies. They can develop their own rules that tell them what to do today, tomorrow and everyday. They can invest the time to learn how to invest intelligently or invest the time to hire investment professionals intelligently.
As I was getting ready to leave a fourth fellow says, “You know, I am a buy and hold investor or a buy and mold investor as you describe. I’ve ridden the market down and I will ride it back up. I do this because my advisor has told me that the proof that buy and hold works is that if you miss the top 10 winning days in any year that your return in stocks drops from 10% per year to almost 0% per year. Is this true?”
I quickly did the math in my head and concluded that it would drop to much less than 0%. I had no idea what it would drop to but I knew it would be far worse than 0% since I know that the top 10 winning days in any year are usually more than 1% per day so I knew his math was probably off. I asked the fourth fellow to explore the antithesis of his argument. I asked him to estimate how much money you would make in any year if you missed the 10 worst trading days in any year. He quickly understood that the theory behind missing the 10 best trading days as a proof for buy and hold was invalid.
I went home after my discussion with this group and downloaded the daily price moves for the equivalent to the S&P 500 from 1994 through 2008. This was a 15-year period and I used the stock symbol SPY as a proxy for the S&P 500. The results were interesting. The average return for the 15 years was 4.89% per year if you practiced what people call buy and hold, even though we’ve learned that it is actually buy and mold. I then calculated the return if you missed the top 10 trading days in each year and the results were as I expected. The rate of return dropped from 4.89% per year to a 16.84% loss per year. This is the alleged proof or propaganda that all mutual fund salesmen have been brandishing for the last 50 years. They spin the phrases “you gotta play to win” and “you gotta be in it to win it,” and right in front of me was evidence that you can’t possibly miss these 10 days. I then calculated what the return would be if you missed the worst 10 days. In this case the return increased from 4.89% per year to 36.95% per year. Once again, right in front of me was proof that you should do everything in your power to avoid the 10 largest drops in any given year. This presents a conundrum.
The point of my calculation is not to draw any conclusion other than to say that you can’t prove that you should stay in the market or that you should buy and hold by referencing some sales line such as “You can’t miss the top 5 or 10 days in the market every year or else you lose all your return” unless you test the opposite. If you test the opposite you learn that avoiding losses is far more productive than missing gains on an equivalent basis.
Let me finish this tale by retelling the story of The Turtles. I use The Turtles to illustrate that you must develop your own methodology or hire a successful methodology. If you don’t you will be unsuccessful as an investor.
The Turtles were a group of traders hired by two legendary traders, Richard Dennis and William Eckhardt almost 30 years ago. The two legends were equally convinced that their philosophy about trading was correct. One believed that trading could be taught. The other believed that trading was a gift or talent that some people had and others did not. They tested their beliefs by hiring these traders and teaching them their exact techniques. When I mean they taught them their techniques, I mean they taught them every last detail. They provided them with the exact techniques that they used to trade their own money. The results were that some Turtles succeeded while others failed. Some failed because they believed that the legends hadn’t disclosed their full approach to trading. Others failed because their personality didn’t allow for the level of risk that the methodology required. Still others failed because they were selective in the actual trades they generated based on the trading system.
As a final example of how one must develop an individual trading or investment methodology let me leave you with something that happened to me almost 20 years ago. I attended a trading conference where I had the opportunity to meet Mr. Eckhardt of Turtle fame. I was at the time using protective stops in my trading approach and struggling with the idea of should I continue or discontinue their use. For those that don’t know what a protective stop is it is a sell order placed either below or above the current price of whatever you are trading that automatically gets you out of your position if the price moves in the opposite direction of your position. I asked Mr. Eckhardt if he used them in his trading and he said, “Only idiots use protective stops.” A few hours later I had the opportunity to meet with Ed Seykota, another legendary trader, and told him about my conversation with Mr. Eckhardt and asked him his opinion. He looked at me quizzically and asked “Did you punch him for calling you an idiot?” I said of course not. To which he replied, “Protective stops, use them, tell your friends about them, don’t leave home without them.” I had just been told two diametrically opposite answers. This lesson never left me and so I pass it on today. To be a successful investor or trader you must develop a methodology that balances your appetite for risk and reward as well as allows you to always do what your methodology tells you to do. Like baby turtles struggling for survival, “Many are called but few are chosen.”