Commitment: Investing is not a Trivial Pursuit

Near the peak of the 1990s bull market, investors threw money at stocks and many made large profits. People became accustomed to large gains and expected them to continue. They failed to recognize that stocks could not go up forever because at some point everyone who wanted to buy at the marginally higher prices has done so. In the absence of new buyers and the presence of any bad or unexpected news the sellers stepped in and the prices began to drop.

The mantra of investing in the late 1990s was that is was easy to make money in stocks - just about anybody with half a brain and a few thousand dollars to invest could hit the jackpot. The prolonged bull market let investors think that making money was uncomplicated. Ever-increasing prices masked basic investing mistakes like paying too much, buying a company which has no viable business plan (many Internet stocks), failure to sell a stock after making a handsome profit, loading up on the stocks in the same hot sector, and believing all the media and Wall Street hype saying "it's different this time". The bursting of the Nasdaq bubble in March, 2000, and its shattering aftermath, changed these views of investing.

Why is making money in the stock market so easy at times and so difficult other times? The answer is simple; the future direction of stock prices is difficult to predict. When prices are in a prolonged rising pattern, most investors (retail and professional) make money by simply being in the market. You can buy individual stocks, actively managed mutual funds or non-managed mutual funds and make money. But when prices start to go down, often retail investors don't know or don't believe the decline is for real so they don't sell. Even many professional investors fail to acknowledge changes in prices and hold on to mounting losses. As a committed investor, you must learn that stock prices don't always increase. And, of course, falling prices can do serious damage to your stock portfolio and financial well being.

Many Wall Street sages tell us that buy-and-hold is the correct strategy for long-term investors. In Stocks for the Long Run Jeremy Siegel writes that the stock market has returned long-term average returns of 7 percent per year. These rates of return are highly misleading because they represent averages. They don't tell us about the strings of years when the market is down, strings of years where is is flat, and years when it's up. The averages "smooth out" these wrinkles in the market and make it look like the long-term performance is ever upward. In reality even though the "long-term" trend is up, short-term returns vary greatly. During some periods actual returns will be far above the average and in other period the return will be far below the average.

Another problem for individual investors is that our definition of "long term" is different from the definition of long term for the market, which is forever. Ordinary people, on the other hand, have a brief period of being invested in the market. Most people start investing in their forties and fifties and stop adding new money to their portfolios at retirement, when they start to withdraw money. This means the long-term view for an individual is perhaps twenty years not 100 plus years.

While a buy-and-hold strategy works for a long period of generally increasing prices, it may not ensure profits in the time-frame of individual investors. For the investor in a multi-year period of price declines or flat price patterns, a buy-and- hold strategy may lead to significant decrease in net worth.

Also, long-term averages are based on overall market performance, which consists of 30 stocks for the DJIA and 500 stocks for the S&P 500. Few investors own 500 stocks. Because the performance of portfolios with fewer stocks tends to be more volatile than portfolios with more stocks, individual investor's returns will be more volatile than market performance suggests. Therefore, some investors will beat the market by a substantial amount, while others will do significantly worse than the market.

Because each investor has a unique investing style, each investor has a unique investing track record. No two investors have the same outcomes. Some do well and others do not. If you take 1000 investors at random and follow their stocks picks and performance for 10 years, there would be 1000 different outcomes. The number of combinations of stocks, amounts invested, and purchase and sale prices is without practical limits. For example, not all owners of Wal-Mart (WMT) stock are rich even though the stock has increased over 900 fold from 1972 to 2002. Table 1 shows the very different outcomes for five WMT investors, each of whom invested $1,000.

Investor #1 Bought 15515.18 shares in 1972, held the shares and their market value on April 12, 2002 was $949,995. This is a buy-and-hold success story! Investor #2 bought the same number of shares as Investor #1, but sold them after a 10-fold increase in less than ten years. Investor #3 bought shares in 1992, held them through a flat price pattern and sold in 1997 with a small gain. Investor #4 successfully timed the purchase and sale to get a 6-fold return in less than two years. The last investor bought near the 1999 peak price and as of April 20, 2002 was losing money. The message here is that "buy and hold" is successful depending on when you buy and how long you hold. The committed investor makes careful decisions, based on detailed knowledge, about both when to buy and how long to hold.

Similarly, the committed investor tracks each stock in his or her portfolio and avoids becoming wedded to any single stock. Three stocks, AOL Time Warner (AOL), Bethlehem Steel (BS) and Colgate Palmolive (CL) present vastly different patterns over a time when the general market peaked and then declined.

Obviously, for the period depicted, an investor in each of the stocks fared very differently. Colgate Palmolive, the toothpaste and consumer products giant, has produced solid stock performance for years. Just as obviously, riding Bethlehem Steel down through a period of market increase did not produce the kind of "historic return" often touted for equities. This once-grand company that produced steel for Manhattan skyscrapers, the Golden Gate Bridge and ocean-going ships failed and went bankrupt leaving long-term investors with next to nothing. Buy-and-hold AOL stockholders have been on a roller coaster.Thus, being married to a bad stock on general principle is a bad thing.

Neither is holding a "market index" portfolio a foolproof and mindless way for the non-committed investor to thrive. The next chart, based on data from Robert Shiller, shows the S&P 500 Index adjusted for inflation from January 1900 to October 2005. The chart shows long periods of rising prices followed by long periods of falling prices. If your investment period coincides with a prolonged market downturn, you will have difficulty making money. For example, an investor who bought in 1929 had to wait until sometime in the 1950s just to break even. From 1969 to 1982 the S&P 500 was in a prolonged decline.

Patterns of past price movements, although not by any means a foolproof guide to the future, strongly indicate that the S&P Index will be "range-bound" for a relatively long time, perhaps 10 years or more. The red line that represents the projected path of the S&P 500 was added by Richard Howard. If the projection comes true, the committed investor will have to carefully pick and trade stocks to make money.

See if you think the investors quoted below have the commitment and knowledge needed to produce "historic returns" by investing in stocks. Then ask yourself, "do I want to be like them?"

Reasons People Use to Make Investment Decisions

The following excepts were taken directly from Money magazine, September 2002 issue.

She'd already purchased shares of Martha Stewart's company: "I'd once met Martha and her hands weren't smooth and beautiful and I thought. 'She must actually do the work.' "

Our comment: Her sort of "gut feeling" all too often overrides careful, committed thought and analysis for many investors. Sometimes it works, but more often not.

Has 100% of his retirement account in company stock. "I have great confidence in the company," he says. Note: the company is Proctor & Gamble.

Our comment: Confidence does not replace analysis, and no retirement account should depend on one stock.

"I entered the market right as tech stocks were peaking in 1999. For a short window, you didn't have to know anything to feel like you could do anything. They'd shoot up in a day. I'd just buy more."

Our comment: The "bubble" of the 90s created many stock-picking geniuses on the way up. Many continued to buy on the downside when the bubble broke.

"We bought Cisco, Oracle and all the hot stocks touted by analysts. We also had some small caps and technical stuff - we were practically day trading."

"My goal is to match historic market return of 10% to 11%." Note: He owns 11 mutual funds

Our comment: The committed investor gets facts straight. Historic returns most often quoted are more like 6 to 8 percent, and there is probably no valid reason to own 11 mutual funds.

Eventually, he says, he'd like to purchase rental properties: "I want to try that and see how it goes."

Our comment: The committed investor would want to know in detail about the business of investing in rental properties ( or any investment) before "seeing how it goes".

Kim had been managing their six-figure portfolio, but its size and changing market had gotten to be too much for her. So last year the couple decided to hire a financial planner. Kim, happy to have the burden off her shoulders, says the planner calculates that they have a 98% probability of reaching their retirement goals. Now, she says, "I feel more confident."

Our comment: A competent financial planner or a broker is a good thing, but they are not a substitute for individual commitment.

The following excepts are taken directly from Forbes magazine, November 12, 2001 issue.

"As the bull market took off in the late 1990s, geometry teacher Robert, now 52, and health care market researcher Nancy, 47, shifted from value-oriented mutual funds to aggressive growth funds such as Janus Enterprise. Since 2000, 40% of their retirement stash has vanished. Floundering for some way out, he has opted for the rather dubious solution of doubling his bets with even more speculative tech funds. They include ProFunds Ultra OTC and Ultra Small Cap, which use leverage to juice market gains or losses. "

Note: From November 12, 2001 to August 19, 2002 the NAV of the ProFunds Ultra OTC has dropped from 33.98 to 12.75 and Ultra Small Cap has dropped from 14.24 to 10.98.

Our comment: Their shift from value to growth probably was a considered decision. It should have been coupled with a formula or target for shifting back out. Making ever riskier bets to recoup losses works about as well in the stock market as it usually does in a casino.

Man, 57 "... parlayed $20,000 in 1988 into $1.3 million in 2000 by investing in the likes of AOL, Cisco and Yahoo. He has lost $650,000 of it since."

Note: As of August 20, 2002 AOL, Cisco and Yahoo have dropped substantially more since November 12, 2001.

Our comment: Riding good stocks down doesn't usually work except in the very long term. You can always take gains and buy them back later.

Man, 58 "The DaimlerChrysler employee had $500,000 in retirement savings all in stocks. He has suffered the agony of watching $200,000 of it vanish."

Our comment: It is probably not ever a good idea to have all of any retirement account in stocks.

Patricia quit working in 1995. Two years later Barry, an environmental health supervisor, got a lump sum payment from his employer and invested 60% of it-the equivalent of ten years' salary-in stock, mainly tech names." Then the market tanked.

Our comment: Over-concentration in high-flying stocks is not a good idea. Eventually their prices drop significantly. The committed investor has an exit strategy for each change in investment.

Our own experience and that of our investing friends tells us that the behavior described above is more common than not. We have made more than our share of dumb mistakes, including:

Human nature probably argues that none of us is immune to questionable or stupid behavior. Here is a short list of simple but deadly mistakes we recite to attempt to immunize ourselves.

This list clearly does not represent rocket science. But we find we are mentally tempted to do one of these fairly regularly. Our suggestion is to print them in large type and tape them to your desk or refrigerator, whichever you visit more often.

Never doubt that buying and selling stocks is gambling. It's, just a special form of gambling, more like poker than roulette. Good poker players win more than they lose regardless of the cards they are dealt. In other words, skill, as well as the luck of the draw, counts heavily.

In the stock market you are risking your money, as in poker, and you are playing against others, as in poker, just a lot more of them. No one in his or her right mind would play poker with professional gamblers without preparing by studying and practicing the game and its techniques. But many people, often with the encouragement of the "buy stocks propaganda machine", enter the market with money that matters to them supported only by a few bromides, including blind faith in the one that says stocks always are the best investment over the long run. John Maynard Keynes, the classic British economist, himself a successful investor in stocks, said it best: "In the long run we are all dead".

For each of us, as individual retail investors, the stock game, like a poker game, has a beginning, a middle and an end. For most of us, the long run is 20 to 40 years of investing before we retire or expire. We don't get to pick the time the game spans. Thus, knowledge and skill, as well as luck, will determine your performance in the game.

Conclusions and Recommendations

The committed investor is as serious about keeping and increasing his money through investments as he is about making money by being employed or entrepreneurial. The investor who spends a third of his life learning to be a salesman, engineer or medical doctor should not be surprised that it takes real study and hard work to be a successful retail investor. Even with the help of effective advisors, only the involvement and knowledge that commitment brings will consistently produce success in the stock market. Therefore, take an informed active role in building your investment plan and portfolio.