It is a familiar story. You buy a stock, because you believe in a company, its fundamentals, and its product offering. It is a bull market, the stock rises, and you pride yourself on having picked a winner.
The Dilemma
Then the stock starts to fall. The stock steadily begins to decline due to circumstances beyond your control. Rising interest rates, the ending of the upswing business cycle, a cataclysmic event, the death of a founder, a merger, a financial celebrity divorce, take your pick – the stock begins a slide into the red. Inevitably, you scream, “Why didn’t I sell when the stock was high?!”
As a stock market investor, it is difficult to watch stock prices fall, and continue to fall, and have your investment successes suffer reversal. When to sell is a difficult question because no one has a crystal ball; no one can accurately predict the future of the market. Yet the whole point of stock investing is to make a profit, which involves knowing when to sell.
It is even worse when the entire market has cratered. The investor yells, “How could I miss the signs of the fall? Why didn’t I sell early when the market started to decline? Why am I still holding this stuff?”
I think I know why. Because investors are given conflicting advice. How do you square “Buy Low, Sell High” with “Buy and Hold”? Had you done the first strategy, Buy Low, Sell High, you would have a profit. But the second strategy, Buy and Hold, can leave you holding the bag. Buy and Hold is investment advice which you hear from all the investing giants. Generally, that strategy works. But when it doesn’t, you miss the tidal wave of profits. You see the yachts leaving. You, on the shore, realize you were supposed to eat the walnuts, not the shells.
The Investing Giants Speak
Warren Buffet says that he sells only when there is another stock that he wants to buy more than the one he is holding. He also sells when, in re-evaluating the economics of the business, he determines there has been a change in the long term competitive advantage of the business. He also sells if there has been a fundamental change in management that has led to downward pricing for the stock.
Buffet has been through eighteen recessions and he does not focus on the broad economy in making stock decisions. He focuses on microeconomics and not on macroeconomics, meaning that he focuses on the traits of a particular industry and how a particular business has a competitive advantage in that industry. He advises to put a set amount of money into the stock market every month and to forget about the economy.
Peter Lynch advises that you have to be careful about selling a great company too early; the greatest mistake is when you sell, and the stock goes on to double and triple. His advice is to ask yourself “What inning are you in this baseball game? How many years have you already been in the stock and what has happened so far? How have things gone in the time that you have owned it? When you are considering selling, you have to ask, why did you buy the stock in the first place?” Lynch advises not to focus on the economy as a whole; but to remember to focus only on the financials of the business that you bought. Regarding the economy, Lynch famously says that “if you have spent thirteen minutes researching the economy, you have wasted ten minutes.”
Howard Marks, co-founder of Oaktree Capital Management, phrases the issue as a matter of management of appreciated assets, and that buying and holding is key because it is very hard to find a really great compounding stock. If you want to sell, then it should be to buy another stock, that is even better placed in the market, than the one you currently own. This is what Marks calls the discipline of relative selection. Before selling, Marks advises that you should run through these questions: What is the opportunity cost of not making the sale and not buying the new stock? Of making the sale and buying the replacement stock? Or, of simply getting into cash? If you can answer each of these questions, you will have analyzed the opportunity and will, at least, have no regrets regarding whether you took a reasoned and researched chance.
All great stuff! Buy and Hold is generally excellent advice, but it does not address the issue of whether you should take the money and run after market conditions have driven up the stock price to exceedingly high levels. It is heart wrenching to watch the stock deflate back to the original price at which you bought, forfeiting all the gains.
So the issue becomes, in the stock market — when the economy is red hot, and stock prices are inflated like a balloon at a hotel prom, all the kids are dancing, the parents are partying, with the music at full volume – what is the economic move to make?
An Alternative View: Meet William J. O’Neill, Founder of Investor’s Business Daily
The founder of Investor’s Business Daily, William J. O’Neill, is in tune with this question and offers this advice. “The secret is to hop off the elevator on one of the floors on the way up, and not ride it back down again.”
That way you avoid the injury of watching the stock price correct and drop to the bottom, leaving you with little to no profit. How? The play goes like this. Growth stocks typically rise in spurts and establish bases where the stock price remains at roughly the same price, for a period of time. Then the stock will break out of the base and ascend to the next base. The strategy is to sell after it hits a base of a 20-25% gain. I call this the Buy Low, Sell A 25% Higher strategy.
What should you do with your gains? You can get into cash, and buy an entirely different asset class, such as real estate. Or you can buy another stock that is rising. Or you can wait, and watch as your stock rises to the next base; and wait again until you have the next 25% gain. On this last point, if you wait for a 20-25% gain three times, you will roughly double your money.
What About the Peter Lynch Ten Bagger? It is All About the Hybrid Approach
Peter Lynch is famous for the ten bagger stock; that is, picking stocks that then rise to at least ten times the price at which the stock was purchased. Having been a personal beneficiary of this strategy, I am the first one to state that this strategy has produced spectacular profits, (one at 41 times the original price!), but it absolutely requires the Buy and Hold strategy to accomplish. I have also experienced a profound state of misery, seeing the whole market correct, eating walnut shells on the shore, while an associate or two got on the yacht.
So how do you get both the illustrious ten bagger of the Buy and Hold camp, while avoiding the precipitous drops and corrections that accompany long stretches of time in the market? How does one get to keep partying by getting off at one of the floors on the elevator with the Buy Low, Sell 25% Higher strategy, while still keeping open the possibility of the ten bagger?
One word. Hybrid. When you buy a block of growth stock; divide it in half. Buy half knowing you are going to buy and hold. Take the other half of the growth stock, and get off the elevator when the stock hits a 25% gain. Once you sell that stock, buy another stock on the rise, and sell it when it breaks out of its base and also hits a 25% gain. Or, keep the same stock, and wait for a 25% gain three times, and see if after five years, you have doubled your money. Then, at five years, compare the two blocks of stock – the Buy and Hold growth group – and the Buy and Sell at 25% Higher growth group – and see which has the greater gain. That will be the only way to know which strategy is more lucrative.
This way you get the benefits of both strategies. Buy and Hold allows you to relax into the possibility of the ten bagger. Buy Low, and Sell 25% Higher, allows you to pocket 25% gains, and become more active investor.
I have a business associate who practices the Buy Low, and Sell 25% Higher strategy and, if she were a stock, I would buy her. She has, bit by bit, accumulated significant wealth and generally punches way above her weight by selling off at 25-30% profits. Her smaller packs of stock profits fattened into a real world down payment in real estate, and now she gets rent. Not bad. Not bad at all.
I have done Buy and Hold my entire investing life. But now, I want to try to avoid the pain of the huge stock drops, which comes with retaining my position in the stock market for lengthy periods of time. Selling a portion of your position after a 25% gain, allows the investor to take profits, try different stocks, and try different asset classes. This helps the investor gain more experience in investing.
In the meantime, through the Buy and Hold strategy, I can still work to acquire a ten bagger with the remaining block that I leave alone. I will share my results from this dual strategy in my future posts, so check back regularly to find out how it pans out!
