The great investing myth (2): Buy and hold 📉📈

Investors know the literal meaning of “buy and hold” but may not understand and do what it means as part of an investment strategy.

Buy <what> and hold <what> matters.

We cannot assume we can make more money by holding. Very very few companies can be Apple, Google, Amazon, Netflix, Starbucks, or McDonald’s that keep growing for years. Some industries are cyclical. Product cycles get shorter and competition can be intense.

What we buy to hold matters.

Hold ≠ Do nothing
Buy and hold ≠ Profits

Fact: The longer the period, the fewer and fewer companies will do well.
Most companies falter. Only a few exceptional companies do well and reward shareholders very well over the long term. Hence, only a small group of exceptionally good companies are worth holding long-term.

Hence, it is easy to lose money; the longer we hold if we are not careful.

To be successful long-term investors aiming to make multi-bagger returns (especially when we are new), we have to do due diligence to

Keep finding high-quality potential investments to invest
When we do our due diligence and invest, we cannot be sure that our investments will be as good as our investing thesis.
Keep validating to hold the best
Hence, we have to keep validating to ensure that our investing thesis remains right and valid. Here, we keep learning and improving our due diligence and investing approaches.
Keep finding the best that we believe to be better than those we have for possible switching
We should keep finding new high-quality stocks to ensure our portfolio remains the best.

This ensures we buy and hold the best investing ideas and sell those who stop becoming the best. Active management is needed especially for those picking stocks. Do not expect profitability and compounding to happen “naturally” and luckily.

There will be competitors introducing cheaper, better and faster product offerings.
Companies make mistakes.
Many companies can become uncompetitive and lose their relevance. Management loses its direction and becomes dysfunctional.
Some can be multi-baggers within a few years before they start to do badly.
Some are cyclical due to the nature of their industry.
Some may rise, fall and rise again.
Very few companies can thrive and deliver outsized returns over years and decades.

We cannot do our due diligence only to find what to buy and stop after we invest. Due diligence is a continuous process.

Time is the friend of the wonderful company, the enemy of the mediocre.
Warren Buffett

In the short run, the stock market is a voting machine. Yet, in the long run, it is a weighing machine.
Ben Graham

In the short term, the share price is heavily influenced by sentiment. Over the longer term, the share price will reflect its true value and potential. The quality of the companies will show up which will translate to their share price performance.

Valuation matters too.
Best does mean the quality of the companies; their valuations matter.

It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.
Warren Buffett

Buying high-quality companies cheaply will give a wider margin of safety and hence, a higher return potential. We hold the stocks believing that their share prices have the potential to go higher. Buy and hold can be highly profitable. This requires effort.

Buy and hold ≠ Buy and hope

A sad truth: Most retail investors tend to hold losing poor-quality companies and sell their winning high-quality companies early. They turn supposedly short-term losing positions into long-term investments hoping that they will recover.

Holding investments should not be like buying items and storing them in storerooms. We are wasting our precious capital that could be better utilised.

Selling your winners and holding your losers is like cutting the flowers and watering the weeds.
Peter Lynch

Buy and hold high-quality; cut poor-quality

Often, people think that “buy and hold” means holding patiently (as in doing nothing) and abracadabra, these investments will gain with time. No, most businesses fail and very few succeed. Holding requires constant effort. We must often validate our investments to know whether to hold or sell. We want to keep the high-quality investments and sell the poor ones.

We are bad at selling poor-quality investments and managing losses but it is a very important skill. Not knowing what to do in a losing position is the path to disaster. The inability to cut losses is a big challenge for retail investors. Money is struck and lost in value with poor-quality investments. Losses are making us less rational. The capital could have been redeployed for better opportunities.

Selling losses is “painful”. As the losses increase, they find it even harder to sell and they hold on. Cutting losses becomes more difficult and “painful”. Holding to losing investments gives hope that the losses will turn lesser and become profitable. Over time, our portfolio becomes a hoarder of poor-quality investments. All the profits made may not be able to compensate for the losses.

Do not hold and hope that things will end well (eventually). Good returns do not just happen.
Companies do not suddenly become good; corporate turnarounds are tough. We must have the rationality to evaluate and the strength to press the SELL button when needed.

The portfolio has to represent the best investing ideas for the long term.

Make your portfolio reflect your best vision for our future.
David Gardner, Motley Fool

Hold = Buy and continuously validate
Ownership is earned.

Beliefs are hypotheses to be tested, not treasures to be protected.

We cannot assume that our investments will do well in the long term just by holding them. Some may slowly zig-zag their way up and others zig-zag their way down. We need to update ourselves to know how well the companies will operate and adapt to the changing environment. Are they becoming more competitive and capturing greater value over time? Do not assume and trust or hope. Multibaggers do not come naturally. Always validate to ensure that what we invest is still good to hold:

Is the investment still meeting our investing thesis?
Do the investments still represent the best available investment option? Are there any better investment opportunities that we can switch to?
Should we add more capital to these existing positions? If not, what are we doing about it?

Have kill criteria and feedback loops. Financial performances and operational metrics serve as feedback loops to our investing thesis.

Also, do not keep watching the share prices. Watching share prices is not useful. It consumes our lives unnecessarily. Learn investing and keep validating the stocks we hold instead or get a life and do other things.

Hold ≠ Never sell

The company is executing its strategy well and delivering good results. There will be periods when the financial market goes irrational exuberance and many are very optimistic and greedy; pushing the stocks to be overvalued. It is time to trim some to lock gains. The financial market often swings from extreme greed and extreme fear that can be decoupled from business performance. It can be a good opportunity to take advantage of such times to buy (when the market is in extreme fear) and sell (when the market is extremely greedy).

Depending on what we are holding. Some companies are worth holding for years and decades such as Coca-Cola, Costco, Visa, and Mastercard. Great businesses can fail because of leadership, economic crises or being disrupted such as General Electric, Nokia, and Credit Suisse. Holding does not mean never sell and hold forever. We have to validate to ensure that the business is still relevant and competitive.

Beware: Holding creates biases.

Holding can create irrationality and biases, especially with large positions, multi-baggers or losing positions.

Comfort zones and the status quo bias
People tend to get comfortable with what they have and do not want to un-hold. Investors tend to invest in what they are familiar with. Being vested, they may have status quo bias, confirmation bias and sunk cost fallacy that they prefer to stick to their knitting. They are less comfortable to be adventurous and explore something less familiar and different. At times, even when they underperform the market; they continue to hold.

Most people prefer to stick with the status quo. It represents a mental account that we already have open, which has sunk costs (capital, time and efforts) associated with it. We become more tolerant of bad outcomes that come from sticking with what we are already holding than bad outcomes that come from switching to something new. We are warier of “causing” a bad outcome by acting than “letting it happen” through inaction. This phenomenon is part of omission-commission bias. Do note that to keep holding and not do anything is itself a decision as to where we stay put; status quo.

Identity and investment: The painful challenge of quitting
Sometimes, we give ourselves an identity and keep pounding the merits of the investments: macro investor, tech investor, dividend investor, Tesla bull, Bitcoin maximalist, crypto “holder”, crypto laser eyes, etc. On the same token, we may give ourselves an “anti” identity on the demerits of some investments: anti-Bitcoin, anti-Tesla, anti-China, etc.

When it comes to quitting, the most painful thing to quit is who we are. When new information conflicts with a belief, we experience cognitive dissonance. Whether it is our actions or new and disconfirming information, when it comes to a battle between facts and changing our beliefs, the facts too often lose out. We identify ourselves so strongly that the identity becomes hard to abandon.

It becomes much harder to quit when we are worried about being judged by others. We are too strongly identified with the “themes” of the investments that we are very convinced and confident with. We get it in our heads that if we do not stick to our original choice, that will reflect negatively on us. We worry that if others see the inconsistency between our present and past decisions, beliefs or actions, they will judge us as being wrong, irrational, capricious and prone to mistakes. The irony is that this desire to be viewed as rational and consistent causes us to become less rational and consistent in the decisions we make. External validity increases the escalation of commitment. The tragedy of all this is that the way we imagine other people view us is often wrong. Those worries we project onto others are just head trash we are carrying around.

This is like being an ardent fan of our favourite sports team. However, having such an identity in investing can hit our profitability when our investing thesis goes awry and we refuse to quit. We lose our rationality to profitability. We can see such investors in social media with their strongly identified investments.

There is a huge difference between having a strong identity and having conviction with a large allocation. The latter would not mind changing their views and selling the position when they think there is a mistake or the investing thesis is less valid and there are better opportunities.

When the facts change, I change my mind – what do you do, sir?
John Maynard Keynes

The best investors do not strongly identify themselves with their investment ideas. They remain rational and establish their understanding based on their due diligence.

Unhold = Admit mistakes, cut, learn and move on

There will always be mistakes made in investments. It is important to learn to cut, reflect, improve and move on. The ability to cut away mistakes is often an important trait of a good investor. It is more important for inexperienced investors and traders. More mistakes happen as we start out and we must know how to deal with mistakes. We cannot be holding on to our mistakes and thereby lock up precious capital for losing investments.

A good reference: The Art of Execution: How the world’s best investors get it wrong and still make millions by Lee Freeman-Shor

Even Warren Buffett makes mistakes. A recent mistake was IBM. In 2011, He bought about USD 10.8b worth of IBM through Berkshire Hathaway; 64 million shares at an average price of USD 170 each. By May 2018, Berkshire Hathaway no longer owned IBM stocks. The company had suffered nearly six years of declining revenue and a share price sinking into the mid-USD140 range. IBM was the first tech company he invested and during that period, he must have been learning. In 2016, Buffett’s Berkshire Hathaway bought into Apple and was constantly adding that he switched out of IBM to Apple. As of 2021, he has more than quadrupled his money on Apple. Apple is by far the largest holding in Berkshire’s US stock portfolio, accounting for 43% of its total value of $293 billion at the end of September 2021. Apple is worth more than the next four biggest positions — Bank of America, American Express, Coca-Cola, and Kraft Heinz — combined.

Rule number 1: Never lose money.
Rule number 2: Don’t forget rule number 1.
Warren Buffett

Do not hold poor-quality investments and let the money dwindle away unnecessarily. Holding poor investments can also add stress. We must have the strength to press the Sell button.

Mistakes offer some important lessons to learn. We are paying for mistakes with losses so do learn and not repeat the mistakes with more financial losses or high opportunity costs.

Buy ≠ Just buy once

Buy does not mean buying a good company once and just holding. As we analyse and validate the quality of the company and its valuation, we may add more as it gets cheaper.

Hold the best
Buy well and hold = f (investing strategy)

Hold the best. However, “buy and hold” means differently to every investor. What stocks investors buy and hold, at what price they buy, how long they will hold and how they deal with poor quality investments are different.

Investors have to decide how “buy and hold” fits their investment strategy which is about how we answer these 6 questions:

1. What to buy?
2. What price to buy?
3. How much to buy?
4. What to sell?
5. What price to sell?
6. How much to sell?

“Buy and hold” only makes sense as part of our broader investment strategy, else it is just a confusing phase.

Don’t hold!

Many do not hold. They hold for weeks and months. To them, it is so easy for the stocks to do poorly (i.e. difficult to be profitable to keep holding):

Most companies perform badly over the long term. Only a few exceptionally good companies do well.
There are lots of macro events that will cause stocks to drop.
Hence, the longer the period punctuated by macro events, the more companies fail and the less profits we will earn.
Some investors use charts to time the markets.
It can be hard to find high-quality investments and keep holding them. It is easier to buy and sell on a shorter-term basis.

As the saying goes: a bird in the hand is worth two in the bush — if you do not sell, you have not taken profits. Many take profits early fearing that the profits may go away. It is easier to sell and book profits.

Everyone is different. We have to decide what approaches suit us and how we can improve to make more money.

Holding is hard. It looks stupid!

Holding looks easy when we look back at the price chart as we see from legendary investors like Warren Buffett and Charlie Munger. To keep holding a few multi-baggers that represents a large portfolio allocation over a long period is hard. Sometimes, it looks stupid.

When our high-conviction stocks keep dropping turning from profit to losses, our confidence and conviction can be shaken. Am I wrong? Does the market know something I do not know? Should I cut and move on? Should I add?
When the share price has wild swings, it can test our conviction. We get confused. What is going on? Is there something that I do not know?
As the share price keeps rising, we are tempted to take a profit. As the saying goes: a bird in the hand is worth two in the bush: realised profits are worth more than unrealised profits. Should I take some profits? We will be tempted to take profit as it keeps going up.
There is always bad news somewhere. Most people trade/invest in the short term (weeks and months). Aspiring longer-term investors can be easily influenced by these fear and uncertainty sentiments that are constantly in the market.
As the stock becomes multi-baggers, the “volatility” increases significantly. Example: We bought the stock for $2 and it is now $20. When it drops 10% from $20 to $18, our returns drop from 900% to 800%. The volatility in our percentage return is due to our low buying price. Again, we ask ourselves: Should we sell? It has been a good gain, why subject ourselves to such volatility?
At times, we may not agree with the companies’ approaches. Examples: They hoard too much cash; they should declare more dividends and/or do more share buybacks. They should introduce a more mass-market product. They should be more shareholder-friendly.
Being a minority investor, there is nothing we can do. Either we have faith in what they are doing or we trim or sell the stocks if we are not comfortable holding them.
Some companies are quiet or vague with their long-term plan and leave the market guessing. Being secretive/conservative about their plans and implementations allows them to have an early mover advantage which can be strategic. This can cause short-term volatility. Again, we need to have faith that it will be good for the longer term.

The above-mentioned situations can occur frequently.

When it drops, we get shaken and nervous — Should I sell?
When it goes up, we get happy and excited — Should I sell to take some profits?

It is back to our investing strategy and whether we continue to have confidence and conviction in the investing thesis. There will be earnings misses, hiccups and investments with long gestation periods.

Zoom out, think long-term, stay rational and keep validating.

It is a journey that we have to keep learning and adjusting ourselves.