Chapter 16
Bits and Pieces: More Buy-Hold Nonsense

I recently read an article where several buy-holders maintained that investors who got out of the market were fools. Let's take a look at their arguments:

Many investors sell because they're afraid, and end up getting out of the market at the bottom.

Sounds like that buy-holder believes that investors panic. Okay, I'll buy that.

They forget that history shows that the market always comes back.

Hmmm, that expert needs to read Chapter 10.

They need to stay in the market for the long term, for more than 10 years.

More than 10 years? This guy can't be talking to my clients. Retired people need to access their money now. Rarely can they wait 10 years to draw money from their investments.

For example, if they held for 20 years…

Whoa. Twenty years? This interviewee is not only dismissing over-50 investors, he's talking nonsense.

“Ten Years” Twaddle

As I've said earlier, investors over 50 years old can't afford to wait even 10 years, much less 20. They invested so that they could retire and have a nice life, not so they could sit and wait around for years before spending any of their money. You could argue that the buy-holders interviewed in the article were speaking to a younger audience, but I don't believe their advice holds water at any age. Do I want my 24-year-old daughter to buy-hold for 20 years? No way. I don't want her to lose half her money in a bad market, even if she may get it back in 20 years.

The idea of a 20-year holding period is fairly recent. Buy-holders used to tout 10-year periods. This past decade has taken the starch out of the 10-year time frame argument, so they've moved on to 20 years. What happens if we have a bad 20-year period? Will they advise us to hold onto our stocks for 30 years?

And, of course there's no guarantee that everything will be hunky-dory in 10 or 20 years. The world changes incredibly fast these days. What are the chances that the stocks you own now will still be good investments in the future? Look at BlackBerry. A few years ago, they made the business phone that everyone wanted. Now the iPhone may put them out of business. And Apple looks good today, but even that's not a sure bet, especially now that Steve Jobs isn't at the helm. Heck, Apple may not even be around in the future. Remember Montgomery Ward? Or how about that highly esteemed company named one of “America's Most-Admired Companies” by Fortune magazine six years in a row? What was that company's name? Oh yeah. Enron.

Can't We Just Use the P/E Ratio?

Many analysts use the P/E ratio as a reason to remain in the market. Let me explain why using market valuations can be a very dangerous way of deciding whether to stay in the market or to sell. The P/E ratio is the price of a stock divided by the projected earnings of that stock. The price of the stock (the P) is easy to find, so there's never any argument about that. That number is the numerator. The denominator, the E, is the projected earnings. That number is an analyst's estimate of a company's future earnings.

The larger the projected earnings, the bigger the denominator (E), which results in a smaller fraction, or ratio. The smaller the ratio, the cheaper (more underpriced) the stock price. And vice versa: the bigger the ratio, the more expensive (overpriced) the stock. To decide whether the stock market is expensive or cheap, the analysts create a weighted average, using every stock on the market.

If you asked a hundred analysts to give you today's P/E ratio and the forward earnings of the market, I bet you'd get a hundred different answers.

Why? Their answers are based (at least in part) on perception, since the E portion of the P/E ratio is an estimation of future earnings. Let's use Apple again as an example. If you asked those hundred analysts what Apple's earnings will be in the next year, I bet some would say, “Without Steve Jobs, Apple is no longer able to compete and will go in the tank for sure.” Others would probably say, “No way! Apple stock will double in value.” Still others would predict that Apple stock will remain the same. How do you decide who's right? You've got to pick one opinion, and if you're wrong—oops, there goes a big chunk of your retirement.

In fact, at the end of 2007 bank valuations were quite low because analysts expected them to continue making large profits on the subprime mortgages they were underwriting. Those bank stocks rapidly lost value in 2008, when the true value of those future earnings became known.

A Word about Warren Buffett

Many proponents of buy-hold use Warren Buffett as a good example of a buy-holder, praising him for sticking to his guns when his investments were getting slammed during the tech bubble. Warren Buffett is a great example of a businessman and investor, but he's not like you or me. Warren doesn't just buy and hold stocks; he buys companies and holds them. When Warren says you can ignore the market if you have stock in a good company, you have to realize that you can't know a company like he does. He is involved in the management of the company. I don't think many of us have that access and privilege.

Money Matters is my financial planning firm. I founded it and built it up with my own money. I'm an investor in this firm. As long as I work here and know what's going on, I'm confident in this company's future. I won't sell it during a rough patch because I believe in our team. I'm sure of our ability to play through bad times, to come out the other side and prosper. I have knowledge and control of my firm. Having that knowledge and control gives me the confidence to buy and hold my own company. It's not the same with my investments. I don't have the same control over the companies that I invest in. We can't compare Warren Buffett's investment philosophy to the typical investor's buy-hold strategy. They're apples and oranges.

And remember, there's a reason they call Warren Buffett “The Oracle of Omaha.” He's one of the greatest investors of all time. He has a talent for choosing companies that have huge potential. The average person or mutual fund company doesn't have that skill. For that matter, no one in the world has Warren Buffett's talent. He's the Michael Jordan of the financial world. Saying that you can make money by emulating Warren Buffett is like saying you can be a great basketball player by copying Michael Jordan. Just leap from the top of the key, fly through the air, and dunk the ball. All basketball fans would love to be able to play like Michael Jordan, but the reality is that no one can do what he does. Ditto with Warren.

By the way, Warren Buffett's investments lost 50 percent during the credit crisis. Yes, they did come back almost six years later, but why take such a large loss if you don't have to?