If you are buying sound value at a discount, do short-term price fluctuations matter?

In the long run, they do not matter much; value will ultimately be reflected in the price of a security.  

• Indeed, ironically, the long-term investment implication of price fluctuations is in the opposite direction from the near-term market impact.  
• For example, short-term price declines actually enhance the returns of long-term investors.  

There are, however several eventualities in which near-term price fluctuations do matter to investors. 

1.  Security holders who need to sell in a hurry are at the mercy of market prices.  The trick of successful investors is to sell when they want to, not when they have to.  Investors who may need to sell should not own marketable securities other than U.S. Treasury bills.

2.  Near-term security prices also matter to investors in a troubled company.  If a business must raise additional capital in the near term to survive, investors in its securities may have their fate determined, at least in part, by the prevailing market price of the company's stock and bonds.

3.  The third reason long-term-oriented investors are interested in short-term price fluctuations is that Mr. Market can create very attractive opportunities to buy and sell.

• If you hold cash, you are able to take advantage of such opportunities.  If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels.  This creates an opportunity cost, the necessity to forego future opportunities that arise.  
• If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.

The Power of Avoiding Losses

Losses occur for three primary reasons:

1. You took bigger risks and exposed yourself to a higher probability of loss.

2. You invested in an instrument that failed to keep pace with inflation and interest rates (e.g. CDs).

3. You didn't hold the instrument long enough to let its true intrinsic value be realized.

There aren't many ways an investor can avoid periodic losses. The best way is to invest all of your assets in bonds and hold them to maturity. You would, of course, experience an erosion in the value of the bond due to inflation. If interest rates rise during your holding period, the intrinsic value of the bond would fall and the yearly coupon wouldn't compensate you for inflationary pressures.

To reduce the chance of losses, you must minimise mistakes. The fewer errors made over your investing career, the better your long-term returns.

We've seen the advantage of adding extra points of gain to your yearly returns. Earnings an extra 2% points a year on your portfolio compounds into tremendous amounts. Beating the market's presumed 11% yearly return by 2% points would translate into hundreds of thousands of dollars of extra profits over time.

The same holds true if you can avoid a loss. When you lose money, even if for just a year, you greatly erode the terminal value of your portfolio.

• You consume precious resources that must be replaced.
• In addition, you waste precious time trying to make up lost ground.
• Losses also reduce the positive effects of compounding.

The effects of avoiding losses can be studied by considering 3 portfolios, A, B, and C, each of which normally gains 10% a year for 30 years. Portfolio B, obtains zero gains (0%) in years 10, 20, and 30. Portfolio C suffers a 10% loss in years 10, 20 and 30.

• A $10,000 investment in portfolio A would return $174,490 by the 30th year.
• Portfolio B would return considerably less - $131,100 - because of three break-even years. The portfolio never actually lost money, but will forever lag far behind porfolio A by virtue of having three mediocre years. Historically speaking, portfolio B's returns aren't all that bad, for the investor managed to avoid losses every year.
• Portfolio C, by contrast, loses 10% in years 10, 20, and 30. It's return of $95,572 was considerably lower. The effects of those three not-so-unreasonable years is to lop nearly $79,000 off the final value of the portfolio. That's what compounding can do. The actual loss in the 10th year was only $2,357. The loss in the 20th year was just $5,004; the final year loss was $10,619. But the power of compounding turned $17,980 in total yearly losses into $79,000 of lost opportunities.

Buffett once summarized the essence of successful investing in a simple quip:

Rule number 1: Don't lose money

Rule number 2: Don't forget rule number 1

Understanding Buffett's frugal convictions

Warren Buffett once joked that he spent 6% of his net worth buying his wife Susie an engagement ring, thus depriving himself of immeasurable millions in future gains.

Indeed, Buffett once was seen picking up a penny on an elevator on his way to the office and remarked to the stunned witnesses, "the beginning of the next billion."

To Warren, a $100 bill lying on a sidewalk should not be valued on its present-day worth or on the present-day efforts needed to accumulate it, but on the future value of the greenback. Suppose, for example, that Buffett could compound $100 at 25% annual rates. In 10 years, his $100 discovery would be worth $931. After 30 years, it would be worth $80,779, unadjusted for inflation.

To understand Buffett's frugal convictions, one must view them from the point of view of mathematics and by using the types of calculation just shown. To Buffett, every dollar not accumulated now or spent needlessly could have productively been turned into numerous dollars later.

Thus, everything you buy or do not buy has the potential to greatly increase or decrease your net worth, depending on the rate of return you can obtain on investments. This principle applies whether you spend money on a poorly chosen investment or on an unnecessary personal expense or luxury item.

Buffett has to make such choices because of his high opportunity costs. In contrast, a household that has no opportunity costs, that is, it doesn't invest or derives no returns from investments, may be just as well off making the various types of purchases.

A household with zero oppoortunity costs can be a net consumer with no detrimental impact to its long-term fortune, but, to Buffett, money saved is money compounded. He has been known buy 50 12-packs of Coca-Cola at once from the grocery store to get a volume discount. Each year, the money he saves buying cases of pop will ultimately increase his net worth by thousands of dollars.

Opportunity costs of our investments

Every dollar spent on a single item is a dollar unavailable for other items. That dollar must provide a suitable return - measured against what you could have earned on tha dollar somewhere else.

Investors should look at their investments similarly.

Because the market tempts us with thousands of potential investments each day, we tend to screen our stock choices until we find those that meet our risk and return characteristics. Likewise, we've learned to benchmark our investments by comparing their performance against the S&P 500 index or some other proxy.

If your portfolio rose just 8% in a year in which the S&P 500 index rose 20%, the opportunity cost on your money was great - you lost the chance at an extra 12 percent a year because the investments you chose did poorly.

Look at all spending decisions as opportunities - won or lost

Most individuals these days are astute enough to understand the power of time and understand the need to fund their own retirement rather than to rely on government programs whose long-term viability don't seem guaranteed anymore.

However, compounding works two ways.

An investment that compounds at, say, 20% annual rates, will swell into a tremendous amount after 30 years.

Conversely, a missed opportunity that could have compounded at 20% a year has the opposite effect on your portfolio. A poorly chosen stock tha rises just 5% a year ultimately costs you tens of thousands of dollars in lost opportunities.

Money that is misspent today and not invested can have the same injurious effect on your future net worth.

At any given moment, you have tens of thousands of investment opportunities worldwide from which to choose. You may decide to put your available cash into shares of Intel or into a home remodeliing project. You may decide to spend $50 at a restaurant, or on a new pair of slacks, or on a new golf putter. You may be faced with the choice of buying a new automobile or funding a college account for a chld. No matter how you choose, every possible use of your money must bring a return - tangible or intangible - or else you should not spend the money. When making the choice of buying, say, shares of Intel or new carpeting, you must think about the opportunity costs of the money spent.

As an investor, you must also look at all spending decisions as opportunities - won or lost. Every dollar spent on a single item is a dollar unavailable for other items. That dollar must provide a suitable return - measured against what you could have earned on that dollar somewhere else.

Columbus's four voyages to the Caribbean

The Joys of Compounding

In Buffett's annual report to partners for the year ending in 1962, he broke cadence from his routine review of the market to discuss "The Joys of Compounding." Anyone reading this passage, even four decades after Buffett penned it, could see the raw-boned logic behind the 32-year-old Buffett's stubborn frugality. As he saw it, every dollar put to productive use magnifies the benefit to society by virtue of compounding. Wasting that dollar had serious long-term ramifications - for him, his partners, even for society at large. What if, Buffett mused in his letter, Spain had decided not to finance Christopher Columbus? The results would be staggering.

In financial terms, Columbus's four voyages to the Caribbean yielded very little for the crown, except to pave the way for generations of future navigators. Think how that $30,000 (cost of the voyage Isabella originally underwrote for Columbus), if spent more judiciously by Spain in the late 15th century, could have greatly increased the wealth of the Spanish people. By 1999, 37 years after Buffett made the analogy, Isabella's $30,000 expenditure could have compounded into more than $8 trillion, nearly the total annual economic output of the United States. Spain would be a world economic powerhouse today.

On this topic, Buffett is behaving as any rational CEO would. If a company generates a high return on its assets, it should withhold dividends to investors and plow as much money as it can each year back into the business. Only when it can no longer generate a strong internal return should a company think about returning money to shareholders.

It's very doubtful that recipients of his wealth could have compounded their largesse at the rate Buffett did. Isn't it better, Buffett believes, to forego conspicuous consumption today if it means leaving even larger amounts for society tomorrow?

"My money represents an enormous number of claims checks on society. It's like I have these little pieces of paper that I can turn into consumption," Buffett told Esquire magazine in 1988. "If I wanted to, I could hire 10,000 people to do nothing but paint my picture every day for the rest of my life. And the (Gross Domestic Product) would go up. But the utility of the product would be zilch, and I would be keeping those 10,000 people from doing AIDS research, or teaching or nursing."

Letting money compound productively creates an enormous economic benefit.

Postulating the value of assets into the future holds meaning for investors who, if they're fortunate, can live many decades. Letting money compound productively creates an enormous economic benefit, not only to investors but also to their benefactors and to society at large.

Buffett is occasionally criticized for not donating more of his wealth to foundations and charities, as many other tycoons have. Buffett's reasoning, however, is perfectly consistent with his investing philosophy. As long as he can continue to compound money at great rates, society would be better off if he didn't give away money now.

He told Ted Koppel in a 1999 Nighline interview, for example, that if he had donated most of his money 20 years ago, society would have been $100 million richer. Because he chose not to donate, society will one day receive more than $30 billion.

Had he given away $100 million in the 1970s, it's very doubtful that recipients could ahve produced $30 billion in economic benefits for society becasue few people alive can compound money as Buffett can.

One day, the value of Buffett's foundation grants will certainly surpass $100 billion and then $200 billion, which would make Buffett's fortune the largest ever donated to charity.

Let time work to your advantage

Choosing good companies at fair prices seldom has produced losses for investors willing to wait patiently for the stock price to track the growth of the company.

"Time is the friend of the good business, the enemy of the poor," Buffett has said many times.

Strong enterprises see their intrinsic value rise consistently, lifting the stock every step of the way. Over a period of 5 years or more, there should be a very close correlation between the change in the value of the company and the change in the stock. Watching great companies increase their sales and earnings consistently is a dream come true for an investor.

The power of compounding begins working its magic as the years progress and allows your net worth to gather momentum and increase (in dollar value) by greater and greater amounts.

What happens to money that is allowed to sit and grow at different rates? Two principles should be readily apparent:

1. Time has a tremendous effect on terminal wealth. The longer that money can compound, the larger the sum will be.

2. The rate of return attained acts as a lever that magnifies or minimises your ultimate wealth. Adding just a few extra percentage points a year to your overall returns can have unfathomable consequences to your wealth. An investor who compounds $1 at 6 percent annual rates has $5.74 in his pocket at the end of 30 years. The same investor who can find ways to obtain higher returns (the purpose of posting all these materials here :-) ) walks away with much more. If you can obtain a 10 percent annual return, your $1 compounds into $17.45 in 30 years. Compounding $1 at 20 percent annual rates compounds into $237.

The mathematics of compounding excited Buffett in his earliest years, and stories abound of how he memorised compounding and annuity tables to help him calculate an investment's merit and to keep his personal portfolio on a straight upward track.

If the Indians wanted to buy back Manhattan

There's the story that, if the Indians wanted to buy back Manhattan, they would have had to pay more than $2.5 trillion by January 1, 2000. That's what the $24 sale price in 1626 would have compounded into at 7 percent annual rates. And the clock keeps ticking.

Next year, Manhattan's theoretical value jumps by $175 billion (7 percent of $2.5 trillion). The following year, another $187 billion is added. The year after that, $200 billion, and so on.

Letting wealth accumulate and compound unfettered and, if possible, untaxed is a potent formula individuals should use to increase their standard of living.

It goes without saying that to an investor, the power of compounding is paramount.

The Power of Compounding

No force exerts more influence on your portfolio than time. Time takes a bigger toll on your terminal wealth than do taxes, inflation and poor stock-picking combined. Time magnifies the effects of these critical issues.

A poorly chosen stock may cost you only $2,000 in losses today, but over time that one suspect decision could cost $50,000 in lost opportunities.

Trading frequently for short-term gains may net you strong gains periodically, but the overall result, validated by time, is to create an enormous tax burden that could have been avoided.

Likewise, persistent inflation exacts a weighty toll on your portfolio becasue it destroys value at increasing rates.

Means and end should not be confused. Buffett once wrote to his partners, "The end is to come away with the largest after-tax rate of compound."

Lost Opportunities

A poorly chosen stock may cost you only $2,000 in losses today, but over time that one suspect decision could cost $50,000 in lost opportunities.

Is Buy-And-Hold The Strategy For You?

Is Buy-And-Hold The Strategy For You?
03/01/01 03:17:41 PM PST
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by RM Sidewitz, Ph.D
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Buying and holding stocks may not be the best approach for everyone, especially those who are unwilling to sit back and take large losses while they wait for their stocks to climb back up.


Many investors believe that buy-and-hold is the best strategy to use for the long term when it comes to stocks. However, over a two-year period, someone who buys ABC Corp. stock at $40, sees it rise to $50, decline to $35, and then rise again, this time to $65, is not getting as good an overall return as he or she thinks (Figure 1). Why, you ask? That investor has lost the opportunity to maximize what his money can do because he has chosen to remain in the market.


FIGURE 1: LOST OPPORTUNITY. The investor may think that he or she is using the best strategy possible when using buy-and-hold for the long term. But is it really the best?

SOMETIMES THEY COME BACK

The truth is that buy-and-hold isn't the best approach for everyone. Buy-and-hold means that even when the market is falling and struggling, you sit, waiting for it to rebound to previous heights. That could take a while; it took almost a year for the stock market to return to its previous levels from the 1974 decline, 10 months to come back from the 1994 dip, but almost 24 months to regain the losses from the 1987 stock market correction. This is time that you're spending just waiting to break even.

Look at it another way. If your portfolio falls in value from $10,000 to $8,000 (or $1 million to $800,000, for that matter), it has dropped 20% in value. That means the market will have to rise 25% just for you to get back to where you were before. Waiting to get back to being even creates the phenomenon I refer to as the "involuntary investor."

The underlying premise of buy-and-hold is that it's impossible to invest in a manner that better insulates you from eventual declines, and therefore, it's in your best interest if you just remain patient. "It'll come back," buy-and-hold believers always tell you.

SOMETIMES THEY DON'T

The truth is that not all stocks rebound; some stocks simply die. Among stock favorites of earlier periods, some such as Chrysler (DCX) went through rocky times, documented in detail in the news media, but eventually triumphed, coming back from the dead.

But some others such as Pan Am (PAAN) do not have such a happy ending. Further, in 2000, many so-called long-term investors in Nasdaq-listed companies found the value of their shares continuing to fall as they were waiting for them to come back. Ultimately, the pain became more than they could bear and many investors sold off their holdings at huge losses.

That reaction is understandable; on a very subtle level, you've been told over and over again to never, ever sell! Think about it. When was the last time you heard about or read a sell recommendation from a stock brokerage research department? In fact, according to Zacks Investment Research, of the 8,000 recommendations made by analysts covering the Standard & Poor's 500 index companies in 2000, only 29 were sells. That's less than one-half of 1%!

How can that be? According to Zacks vice president Mitch Zacks: "It's not that they're oblivious to things getting worse [at companies]. But the way an analyst gets fired is to damage an existing investment banking relationship with a company or sour a future investment banking relationship. The way you do that as an analyst is coming out and telling people to sell a stock."

The unavoidable result is that there is simply no one willing to tell you to get out of the market, ever. "You'll miss the next big move if you're not in the market," you're told. You are not told that the price of waiting for the next big move is you have to sit through substantial market declines that erode your assets. That's a big price to pay.

A buy-and-hold strategy for stocks is an investment approach that takes power away from the long-term investor. But there is a better way, which I will explain in my next article.

R.M. Sidewitz is president, chief executive officer, and founder of Qi2 Technologies, LLC, an investment management company, and the managing member of Qi2 Partners LP, a domestic hedge fund. For additional information on long-term investing, go to www.longterminvestor.org.

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Opportunity Cost and Opportunity Lost

A value investor's mind operates in a continuous buzz, deciding whether an investment is achieving its best possible returns or whether it should be replaced.

Value investors like cheap stocks, but if the stocks get cheap on an investor's watch, the investor should consider a serious reappraisal of a company's prospects.

Value investors continuously check for dead branches and aren't afraid to get out the pruning shears. Value investors know the cost of dead wood.

Likewise, the frugal citizens, value investors avoid squandering money that could be put to better use and always think of the best use for their capital. For Warren Buffett, a penny found on a sidewalk is "the start of the next billion."

Pruning the Dead Branches

It isn't hard to show what happens when you hang on to losers, or even the inferior "winners."

Click here:

Compared to market returns, an investor underperforming the market by 2% (or achieving an 8% return) falls:

• 17% behind a market performer after 10 years,
• 31% behind over 20 years, and
• 42% behind over 30 years.

An investor underperforming by 6% loses:

• 43% to the market-performing investor over 10 years,
• 67% over 20 years, and,
• 81% over 30 years.

That's quite a price to pay for underperformance.

Now, if your investments are producing negative returns, the results can be quite ugly indeed.

There's a lesson in these numbers: Don't hang on to chronic losers! Not only do you lose, but you also lose the out on opportunities to gain. If it's broke, fix it!

Opportunity Lost

The mathematical power of compounding makes a small increase in investing return, or i, very compelling. To increase the chances of achieving a higher i, buy cheap. Buy expensive, and you'll be lucky to match market returns.

Investors should know how beating the market with even slightly higher rates of return is a shorter path to wealth.

This is especially true if the investments are left on the table to perform, and perform consistently, over time.

What about investments achieving less than market average return?

What happens when you cling to these investments?

Are they like a bad marriage, not only producing inferior returns but also consuming valuable time that you could put to work elsewhere?

From an investment perspective, the answer is yes.