Buy and Hold and Cheat

by

Brad Castro

Actually, it’s customary that, whatever form of trading or investing you’re advocating or promoting, to point out the weaknesses in other trading or investing styles. Frequently, mischaracterization is also involved to speed up the persuasion process.

I try to be better than that. Yes, I have opinions and biases, but in the end, I want to see the best ideas win on their own merits rather than weaker ideas gain credence through rhetorical trickery.

So before I point out the problems with buy and hold investing, let me first acknowledge its strengths:

1. There’s arguably no better style of investment during long, extended bull markets (e.g. 1982-2000).
2. It’s worked pretty well for Warren Buffett.
3. In theory, it protects investors from expensive and inefficient overtrading.

Now for the bad news about buy and hold investing:

1. It appears we’re in a secular bear market instead of a secular bull market. At the end of 1999, the S&P 500 closed @ 1469.25. Eight years later, at the end of 2007, it closed @ 1468.36. You don’t get much flatter than that. But that was before 2008 which saw the S&P 500 plummeting 38.5%, ending the year at levels not seen since 1997.
2. Most people aren’t Warren Buffett. I’m not much into hero worship, but let’s be honest—Buffett is an extraordinary investor. He makes a rather simple but extremely difficult process look far easier than what it really is. He has the ability to identify truly strong and enduring businesses and he’s disciplined enough to purchase those companies, in whole or in part, only when they’re attractively priced.
3. Most buy and hold investing takes the form of investing in mutual funds, index funds, or ETFs. At best, you diversify yourself into mediocrity and merely match the market (and during secular bear markets, which we now appear to be in, that’s a recipe for breakeven investing at best—check out this external article from 2001 that includes a table showing both the individual and the average annual returns of all secular bull and secular bear markets going back to 1802). And at worst, due to fees and overtrading by fund managers on your behalf, you are far more likely to underperform the broader market.

Compounding Growth

To really illustrate the power of compounding growth, check out the following table for a stock trading at $50/share.

For a new investor (i.e. one who purchased the stock at $50/share), calculating the returns if the stock goes higher from that point is fairly straightforward and uneventful. For each dollar increase in the share price, the new investor gains 2% in unrealized gains.

But what about investors who bought in much earlier? The chart above illustrates the profound power of compounding growth over a long term horizon. Take the hypothetical case of an investor who recognized the growth potential of this particular company back when its stock, split-adjusted or otherwise, was trading at $5/share (admittedly, years, perhaps even decades, earlier).

For the early investor above, a $1 increase in the $50/share price doesn’t represent a 2% gain—it represents a 20% gain!

Buy and Hold Selection

For every Home Depot, there are countless Ernst Home & Nurseries. For every Starbucks, there are dozens of Krispy Kremes. And just because a company has been around for decades doesn’t mean it was ever a good buy and hold investment. Pick your favorite American auto manufacturer or airline and see for yourself.

So although buy and hold investing has great theoretical potential (the power of compounding growth), successfully executing the strategy is a rare achievement.

If only you could figure out a way to stack the deck in your favor . . .

Buy and Hold and Cheat

What Leveraged Investing understands is the critical importance of getting a great entry price on a stock. For the long term investor—especially when dividends are involved—it’s the buy price of a stock that’s more important than the sell price.

Why? The lower your cost basis, the higher the rate of return your investment produces for each subsequent uptick in the share price and the higher your overall dividend yield will be.

Additionally, on the capital appreciation side, if you pay too much for even a great company, you may have to wait several years to see your investment begin to generate the positive results you had hoped for. And if you pay too much for a mediocre (or worse) company, you may never see positive results.

The beauty of Leveraged Investing, however, is that, through the power of options, your entry price in a stock investment does not have to be a single static number. The traditional investor calculates the simple cost basis of his or her positions by taking the total number of shares divided by the total amount paid for those shares (including commissions).

But the Buy and Hold and Cheat investor calculates cost basis much differently—he or she calculates Adjusted Cost Basis. An adjusted cost basis is just that, a number that’s always on the move, always adjusting, always (hopefully) getting smaller. With options, the amount you pay for a stock can become dynamic and fluid, giving you returns even when the stock market goes nowhere.

How is this possible short of inventing a time machine? The simplest analogy is to think of the Buy and Hold and Cheat method as getting rebates on your stock purchases—before, during, and after those purchases.

How’s that for stacking the deck?

And as an added bonus, you never have to worry again about portfolio rebalancing.

I anticipate that simply buying and holding will be one of the worst performing investment styles until the next secular bull market emerges (however many years away that may be), but Buy and Hold and Cheat allows you to create your own bull market anytime you wish.

For a more indepth exploration of the specific strategies and issues involved with this process, see the related site article, "Adjusted Cost Basis with Options."