A great deal of Wall Street’s brainpower is devoted to gaining an edge in short-term trading. If you read brokerage house research reports, they are frequently focused on what stocks are picking up momentum and thus should be good buys — over the short-term. On the other hand, there are those investors who buy and hold for the long haul.
In this post from his blog, Kudlow’s Money Politic$, Larry Kudlow talks about traders versus investors.
‘…Last night I asked Jeremy Siegel, Wharton Finance professor and author of “Stocks for the Long Run,” the following question: Who does better, long-term investors or traders? That’s really the key question. Siegel said it’s a no-brainer—definitely long term investors. He conceded that there’s a very tiny few who can buck the trend and succeed in the short term game. But on the whole, it’s no contest, you want to be a long-term investor.
I posed the same question to Trend Macro CIO Don Luskin. Here’s what he had to say: “There’s no question about it. The great myth of trading is that it’s the very, very few survivors in the trading game who show their face to the public, who come on CNBC. What you don’t see…are [the] 10,000 who are driving cabs and flipping burgers somewhere.”…’
Don Luskin kind of mangled his comment, but his point is a good one. When we hear about someone who was successful in short-term trading what we do not hear about are the thousands of traders who lost money using similar strategies. One analogy to consider has to do with coin tosses. If one million people paired up and tossed a quarter, then half would call it correctly and half would fail. If we repeated that process, after 20 tosses, we would have one winner who had called the toss correctly 20 times. No doubt this hero would get rich off promoting his or her ‘system’ for calling tosses correctly with advertising that might go like this, “I made a fortune with my patented wrist flip and you can too!”
Whether we are talking about stocks, real estate or a business, one of the enduring themes of long-term investing is to defer taxes as long as possible. Two related factors are causing investors to rethink this tried and true strategy. First, capital gains tax rates are at a historically low point. Second, tax rates may be going up in the next few years. As this article points out, investors are starting to change their behavior [emphasis added]:
‘Investors may be starting to sell stock at today’s low capital-gains tax rate because they expect it to rise in a year or two.
The standard top tax rate on long-term gains is 15%, but it’s set to rise to 20% in 2011. Many financial advisers believe a Democratic administration in 2009 may raise it even higher — and sooner — and some are urging clients to consider selling off big stock positions now to capture the current rate. Long-term gains are those on investments held for more than a year.
“You should never let the tax tail wag the dog,” says Edmund T. Hyland, global investment specialist at JPMorgan Private Bank, a unit of J.P. Morgan Chase & Co. “But we think there is a window of opportunity with the rate at 15% to maybe be quicker to diversify than you might otherwise have been. We’re encouraging clients who have concentrated positions of low-basis stock to think about this.”…’
This article focuses on sales of stock, but the same issue applies to any appreciated asset such as real estate. Many investors seeking to defer taxes on real estate do a 1031 Exchange which allows them to exchange one property for another without realizing a gain. However, those considering such a move may want to rethink it because higher capital gains tax rates in the future could reduce or even eliminate the benefit of tax deferral. The article continues:
‘…Many tax experts are laying odds that a new administration will move quickly to raise the top rate even higher than 20%, according to David Shechtman, chair of the tax section at Drinker Biddle & Reath LLP in Philadelphia.
The idea of Congress cutting rates seems far-fetched. “Never say never, but it’s hard to imagine that the standard cap-gains rate is ever going to go below 15%,” says JPMorgan’s Mr. Hyland…
‘...Prior tax increases have led to a surge in capital gains being realized ahead of time. After Congress passed the Tax Reform Act of 1986 and the top rate on gains rose to 28%, there was a “surge of recognition of capital gains” in the last months of the year, says Len Burman, director of the Tax Policy Center, a joint project of the Urban Institute and the Brookings Institution. “People sold a lot of assets to avoid the increase.”…’
At this point, there is no certainty that tax rates are going up, but I think it is reasonable to conclude that tax rates are not likely to go lower. While I see no reason to sell an asset just to take advantage of low tax rates, I also think delaying a sale just to defer gains is less attractive now because of possibility that capital gains rate will climb in the next few years.
It has been 20 years since that memorable day when the Dow Jones Industrial Average fell over 22%. The fact that the drop was only 508 points should put things in perspective for us in the sense that a comparable drop would have to be over 3,000 points.
1987 was also a memorable year for our firm because we opened our doors in August, 1987. At that point, we did not have many clients, our track record was nonexistent and few people could spell or pronounce our firm’s name correctly, so we figured we had an opportunity to do something new and different. Our firm, Brouwer & Janachowski Incorporated, pioneered what was then a new type of investment or financial advice. We developed portfolios of no-load mutual funds for our clients instead of the more traditional portfolio of stocks and bonds. We still invest this way today — 20 years later.
That year I was in the middle of writing our first investment book, Mutual Funds: How to Invest With the Pros (Wiley). Since 1987, many things have changed, but our beliefs and values as financial advisers have remained remarkably constant. Here’s what I wrote about investing way back then:
‘…Planning your next investment move these days can be like driving in the fog. Even if you manage to get home, your nerves are shot. Was it worth the aggravation? Or you may feel you’ve been left behind-stuck in the slow lane as a red Ferrari screams by at 80. The stock market has taken off, but your stocks haven’t. Or you hear about takeovers and leveraged buyouts where savvy investors made a killing-but when you finally act, it’s on a stale ‘hot’ tip and your fingers get singed.
Before you spend time learning how to invest, first decide if you should be investing at all. Before you put money in mutual funds or other investments, think hard about your finances. Do you have good health and life insurance? Have you salted away several months’ living expenses in a money market fund or a bank account? Have you contributed to your individual retirement plan (IRA) or your company’s retirement plan? Make sure you have taken care of these personal investments before you look further.
BROUWER’S BASICS FOR BULLETPROOF INVESTING
Pros invest using simple, common-sense rules. They’re human, too, so they need a disciplined work and decision-making environment. Sounds complicated, right? Don’t believe it. Just follow these four steps
Set clear objectives and guidelines
Use investments that mirror your objectives
Coattail with the pros
Track results, cut losses, and stick with winners…’
About the only thing I would change in this passage — 20 years later — is that I would write ‘…use investments that reflect your objectives rather than mirror them.’ Other than that, I agree with everything I put down 20 years ago. However, it is just as hard now to do these things as it was then. Just because solid, long-term investing is conceptually simple, that does not mean it is easy.
Here is an example of another tale from the Crash of ’87, excerpted from a later book, Mutual Fund Mastery (Times Business) for which Steve Janachowski and I were co-authors. It was published in 1997, 10 years after the Crash of ’87:
A Tale of Two Investors
‘…On Monday, October 19, 2020, the U.S. stock market tumbled 22.5%. That 508-point plunge set a record for the worst single day in our financial history. Economists, politicians, journalists, investors and the public, as a whole, were stunned. Many, including some of our clients, predicted a worldwide economic depression…
…That week, many clients called us. Most were very concerned, some were in shock. Of all the calls, two really stood out. One man, a physician, was frantic. When told that we were buying more shares of stock mutual funds for his account, he yelled, “Are you crazy? Haven’t you read the paper? We’re going into a depression. Stocks are going to plummet. Get me out!” So we did, reluctantly.
We also had a call from another client, who saw things very differently. In fact, he grilled us on what and when we were planning to buy. He wanted to be very aggressive because he thought this was the buying opportunity of a lifetime.
These two investors had strategies and philosophies that were worlds apart. The first investor, we’ll call him Dr. Doom, lived in fear. He had lost 9% in the Crash and he felt he had to salvage what he could from the wreckage and protect his assets from the coming catastrophe.
The second investor, we’ll call him Mr. Growth, believed the U.S. stock market was inevitably going higher. To him, there would inevitably be down years when things would appear to be falling apart. However, he believed that stocks would always come back higher and stronger than ever.
Along with Mr. Growth, we believe in the U.S. (and the world) economy. There will be downturns and tough times, but the future is very bright. This is not to say that buying stock mutual funds is risk-free. We will undoubtedly have to face severe declines periodically in the future. Buying stock funds is a winning strategy, most of the time, but not all the time. And those off years can really hurt.
No one can accurately forecast when the downturns will come or how long they will last. But we can predict that Mr. Growth, and others like him, will prosper over the years because they have found a proven strategy for success. They look at the big picture and invest only for the long haul. Mr. Growth’s only major problem will be reining in his natural optimism.
Meanwhile, Dr. Doom and his fellow sufferers have a bigger problem. They agonize during good times and bad. During down years, they conjure up countless reasons why things are going to get worse. And they get plenty of encouragement, because things always seem worse than they really are during the bad years. During good times, Doomers often sit on the sidelines, wringing their hands and wondering whether to jump in the game. And when they do, the timing will probably be wrong. For Dr. Doom, his emotions, fears and fantasies have become a straitjacket that almost certainly ensures poor performance and paltry profits.
Do you see any similarities to your investment history in this story? It is a true tale and that truth extends from our two clients right through to millions of investors. Would you be closer philosophically (and in practice) to Dr. Doom or to Mr. Growth?
We are not suggesting you should try to be like one or the other. Just listen to your instincts. Both types can be very successful. Both also carry within them potential problems. Dr. Doom often sees a problem where none exists. And Mr. Growth can fall into the trap of going full speed, despite the fact that there may be a steep drop-off dead ahead. Our goal with this story, is to illustrate two abiding themes in the investment world-and in human nature-greed and fear.
Investors are often asked about their investment objectives. Are they investing for growth or for income? Growth investors seek capital appreciation. They want more and they are willing to take significant risks in order to get it. Income investors want a little growth too, but their primary goal is to preserve and protect what they have. For them, the fear of loss is more dominant.
Mr. Growth and Dr. Doom are ideal examples of these two themes. One is motivated primarily by growth, or, in other words, greed. For Mr. Growth, fear of loss from a declining stock market is not a big deal. But Dr. Doom seeks primarily income and is driven more by fear of loss than by greed…’
Though these words were written over 10 years ago, I would not change anything either. The twin poles of fear and greed motivate human beings as strongly today as ever. It does not really matter whether you are primarily focused on growth or income, but rather what matters is that you recognize your natural instincts and that you take them into account in your investment strategy.
And, it is also critical that you keep market downturns in perspective. At that time, the Crash of ’87 seemed calamitous to investors. Now, 20 years later, it is just a footnote in the annals of stock market history.