Volatility, otherwise known as the fluctuation that affect the prices of publicly traded assets, is a subject that strikes fear into the hear of many an investor. Yet, few investors will openly admit it bothers them.
“I’m in it for the long-run” they tell themselves.
The facts don’t actually support all this investing bravado. According to data by Ned Davis Research on the NYSE, investors have been holding for shorter and shorter periods since about the mid-1980’s.
In my opinion, holding stocks for a mere 8.3 months does not constitute “long term” in most playbooks. (I usually define long-term as a minimum of 5 years, with 10 years being a more realistic long-term holding period.)
Why should investors hold stocks for the long-term?
Tons of research has been done on the subject, and essentially lower turnover means higher portfolio returns. To quote a University of California study that looked at the performance of 78,000 portfolios, “trading is hazardous to your wealth.”
In the study, the lowest turnover portfolios saw the best performance and the highest-turnover portfolios saw the worst performance. Much of this under-performance could be attributed to stock trading costs. In the past, trading was a much more expensive endeavor. This is one of the key reasons why actively managed mutual funds have historically under-performed index funds. Turnover is expensive.
Today, things are a little different — we have an environment where the cost of trading is approaching zero in many cases. Yet active management didn’t start outperforming when the cost of trading dropped.
Quite simply, patience is still a virtue, even in a low/no cost trading environment. Compounding takes time — Better returns come from longer holding periods.
The Rise Of The Index Fund
One of the reasons why index funds have become so popular is because they allow investors to hold stocks without all the drama.
For example: Domino’s Pizza might have had a bad quarter and the stock might sell-off in excess of 8% in a single day when the news is announced.
“The End of Domino’s Pizza is Near!” — The news headlines might pronounce. But the holder of an index fund isn’t going to do anything to his Vanguard account based upon that scary headline. He or she is going to look at that headline and say “huh, that’s strange” and then go about their day unconcerned about the future prospects of Domino’s Pizza.
Individual holders of stocks however, could be tempted to trade. This is exactly why index funds are the way to go for most investors. All the noise from the news and stock market media can sway investor’s emotions one way or another, to buy or sell. With index funds you don’t have that same level of noise that individual stockholders have to deal with.
It’s no wonder than index funds now hold about 36% of U.S. equities, and that will likely pass 50% in the next couple of years.
So why isn’t the holding period of NYSE stocks above 1 year? …Even with the incredible rise of index funds?
Apparently, index fund investors are still trading too often. It’s not just individual stocks! According to one recent study on index-fund ETFs, funds are launched specifically to take advantage of “ingrained psychological forces and habitual cognitive biases” that cause investors to jump from one hot ETF to another.
Despite the fact that index funds are easier to hold, investors are still chasing performance in index funds!
Do You Have The Strength To Hold?
As the data shows, holding through thick and thin is no easy task. The news media might suggest a recession is coming, making you believe its a good time to move into cash. Perhaps you believe that new technology index-fund is going to do well. Or, after a long bull-run, maybe you feel it’s time to take profits.
There’s literally dozens of reasons why investors might want to sell or trade investments. The fact of the matter is, we shouldn’t. Investors frequently sell and move into other assets at exactly the wrong time. We can’t predict the future and humans are terrible at market timing.
In order to realize good returns from equities you must hold stocks through thick and thin.
How is it done? To quote Peter Lynch (the famous mutual fun manager):
“The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them. Stand by your stocks as long as the fundamental story of the company hasn’t changed.”
It’s this understanding of the “fundamental story” of the business that I believe is missing from most investor’s repertoire.
Take A Business Perspective
Imagine for a moment, that you are part-owner of a cafe. This cafe serves coffee’s and sandwiches 7 days a week. It’s a decent business, spitting off reasonable returns in-cash to you and your partners every year. Revenues have grown modestly every year since the cafe opened, and customer traffic has been growing as well. There’s even talk of opening more locations during business meetings, but for now it’s just one location.
Meanwhile, a newsstand across the street that sells newspapers like the NY Times, the Wall Street Journal, and so forth. Every day on your way to the cafe, you pass by all those newspapers with their wild headlines. Sometimes the newspapers say “The economy is booming” and sometimes they say “The economy is headed for recession!”.
Would the headlines ever cause you to sell your share of the cafe? It’s unlikely. You are a business owner after-all, and what you care about most is serving the customers that come in the door.
Sure, there will always be economic fluctuations — fewer customers might start eating at the cafe if the economy goes into recession. Perhaps a lack of free spending cash makes customers start to spend less on each visit. Either way, you are unlikely to sell unless the fundamental story of the business changes.
What constitutes a fundamental change in a business story? Any major disruption to earnings that is most likely a permanent shift in customer behavior. Cafe’s could become unpopular and everyone could order sandwiches and coffees from Amazon (unlikely, I know… but this is hypothetical after-all).
To a sensible business owner (like that of our a cafe’ owner), trying to jump in-and-out of a business just to eek-out slightly higher returns looks like absolute madness.
Our job as stock investors is to think and act like sensible business owners. Through our ownership of common stocks we ARE business owners!
Holding Isn’t Easy
You’ve probably heard all of this advice before — Hold stocks, don’t trade a lot, think like a business owner, etc etc. But at the end of the day it seems that most investors just keep ignoring this advice. Why?
I can only speculate here, but it might have something to do with the mix of capital gains vs. income. Business owners like a landlord or cafe-owner focus mostly on income. Yield from the investment.
In contrast, common stockholders are laser-focused on capital appreciation. They focus on growth and want it fast! That fast growth orientation isn’t always a good thing.
In order to achieve fast growth, investors are forced to purchase the stock at highly inflated prices and all the profits need to be funneled back into the business to achieve it.
This intense focus on growth becomes a problem only when a recession hits — fast growth oriented companies often take the biggest hits during a recession (which causes weaker shareholders to run for the exit).
Want my advice? If you’re thinking about selling stocks — Just take a breather. Business news is designed to get you excited and anxious about what stocks are doing, but good decisions can’t be rushed.
Take a break. Ignore the stock market for a week. Maybe read a book, and the latest annual reports. Take time to think. Is the investment likely to resume growing once economic conditions improve? Are you satisfied with the income you’re receiving from that investment?
If the answer to both those questions is ‘Yes’, then you should really have no reason to sell.