It’s time for clarifying some concepts, in particular the eponymous term of this website – ‘speculator’ – and why speculation beats classical long-term ‘buy and hold’ (B&H) investing tenets any day of the year. This topic could fill a book, but the crux is as follows.
What is stock speculation?
Bernard Baruch, the statesman and financier of the early 20th century, dispelled the bitter taste that people get with the word ‘speculation’ in his autobiography My Own Story:
This conceptual understanding of speculation has been corroborated by many other highly successful market operators, such as by ‘Ultimate Wall Street Pro’ Vic Sperandeo: “Gambling is taking a risk when the odds are against you. Speculating is taking a risk when the odds are in your favor.”
As much B&H long-term ‘investors’ despise the words speculation and betting, in the end they just accurately describe what exactly they and many value ‘investors‘ are trying to achieve – betting on a future expectation/hope/wish of ‘should be worth‘, which is different from the present ‘is worth now‘. ‘Betting’, because no one does know whether the gap will actually be closed, and in what time frame.
As George Soros stated, anything that is commonly called investment is in fact speculation, because “if you successfully anticipate the future you make a speculative profit.” In the stock market, it’s important to realize that we all speculate. If you think you don’t, you’re fooling yourself.
Unless you’re one of the select few who are venture capitalists, invest in private placements, or manage to actually grab some shares in an initial- (IPO) or secondary offering from companies themselves, you are trading on the secondary market – what’s generally known as ‘the stock market’. >99% of people who own stock do not (and cannot) ‘invest’ – never have, never will.
You are buying Apple stock from a Spanish lady who sells it to buy her children a house, your friend is selling Tesla stock to a Canadian money manager who thinks the price is heading up, and so on. Your money is funneled into a network of people betting on rising and falling prices, and it is spit out into someone else’s pocket who made the right bet, the right speculative call, not to the company that you think you ‘invested’ in.
We are all speculating against each other on what the price of these tulip bulbs we call ‘stock’ might be worth to another nameless buyer in the future.
Unsupervised “long-term investing” is inherently risky
By not grasping that everybody speculates, there evolves a dark side to the concept of long-term investing, a side that most people conveniently sweep under the carpet – most from pure ignorance and not having experienced true market downturns, others from fear of having to admit to others and, more poignantly, themselves that they were wrong.
Before I am shelled with uproar – yes, long-term B&H ‘investing’ can and does work, if done right and under specific circumstance. What can make it work is that you:
- cannot try to make ‘active’ decisions, such as selling in market declines,
- have to hold for very long amounts of time, and
- can not have a specific need at a specific time to take out the money
The only problem is that 1) the vast vast majority of people do not do it right – they sell in panic, average down at the wrong time, buy too early or too late, hold too short or too long, become impatient, and that 2) people do want and need to take out money at some point when it cannot wait any longer – e.g. paying for retirement, real estate, children’s university fees, large purchases, emergency surgery, expensive litigation, and so on. But if we can’t liquidate when we really need money, why ‘invest’ at all?
Comparing approaches
Let me explain the problem with the long-term B&H approach with a quick comparison of how the equity curves of four types of market participants typically look – the stock-picking B&H investor (who is in fact a speculator that does not manage risk), the mutual fund B&H investor, the more modern B&H passive ETF cultist, and the trend speculator.
The below chart is simplified, assuming for every single strategy that they are performing better than the average of their category, AND the market. That is a momentous concession I am giving, as the vast majority of stock-picking investors and even professional fund managers in fact consistently under-perform each other and the market.
I’m also assuming the speculator does not go net short the market during downturns (as many long/short hedge funds do), which would make performance even more outsized.
Characteristics of long-term investing
Note from the comparison the following points for B&H strategies:
- Less diversified B&H investors may slightly outperform large mutual funds and both the market, but not meaningfully. Significant diversification dilutes performance of both, even if they happen to allocate a portion of their portfolio to some winning stocks
- B&H stock pickers and mutual fund investors potentially lose more in market downturns than a pure passive index-tracking ETF strategy
- All lose gigantic amounts of capital in a major market downturn, leading to the typical boom-and-bust shape of their equity curves. In the very long run, they make profits
- For all B&H strategies it takes a long time, usually years, just to break even again after digging out of the hole post a major downturn, and recover back to the previous value of capital
- Until mutual fund and stock-picker B&H investors start slightly outperforming the market again (and again, the majority actually don’t), they have to dig themselves out of a deeper hole than even the passive ETF-tracker holders
The argument of mutual fund and passive investing enthusiasts is that “the indices always come back”. This is true, but this can take years to happen, or markets can go sideways without profits for decades (see below graphic of the Dow Jones from the mid-’60s to the early ’80s).
Time that many don’t have, as I will discuss below.
The stock-picking buy-and-holder
Even worse off are individual stock-picking long-term holders that do not control risk … because some stocks do never come back to their old glory.
Just have a look at Xerox (XRX), Cisco (CSCO) or Intel (INTC), where holders are now still under water after more than two decades, or capital is lost completely. All these, and many more, were touted as forever-winners, and immortal blue-chips before and during the late ’90s. The equivalents of today’s Apple or Salesforce.
Similarly, look at long-term charts of Citigroup (C) or American International Group (AIG). For decades, they were considered safe bets and too big too fail. They got slaughtered during the 08/09 crisis, lost 85%-95% of their value, and never recovered again to date.
There were hundreds of big high-quality stocks like these that fell off a cliff over the many decades, and any exemplary selections as above are already the result survivorship bias – some drop to zero, and many stocks are de-listed after major downturns. They fade out of existence, so the next generation of ‘investors’ will never learn from their stories. Just think of Enron, World.com – more ‘safe bets’ back in the day that blew up and died on the roadside.
The risk-controlling stock speculator
On the other hand, a stock speculator focuses on heavy portfolio concentration into true market leading stocks, and on strict and responsive risk capping and exposure control in hostile market environments. The latter takes the speculator out of suffering stocks, to >50% cash during small market downturns and to 95-100% cash at the start of large market downturns (yes, you can time the markets that well…)
As a result, the equity curve of a speculator:
- has minimal draw-downs in market downturns
- after a downturn, she does not need to recover capital funds to values previous to the downturn; she virtually picks up where she left off
- the growth rate of the speculators’ capital is much stronger than the B&H strategies due to relative concentration paired with risk management
Learning to watch out for yourself
The average person not involved with financial markets but still intent to put their hard-earned money to work often emphasizes that they have no time to actively manage their stock holdings, or not sufficient knowledge to not rely on wide diversification.
I believe these are fallacies.
First, if one does not have the time, one should make it – because, we’re not talking about a hobby here, but our financial future and safety.
Second, not everyone has to be poring over a screen every waking hour and place orders frenetically. In fact, half an hour in the evenings or 3-4 hours on weekends or less are sufficient for monitoring one’s holdings and save people from drawing their account down severely in bad times, with the proper knowledge. There are plenty of successful speculators who make their brief decisions only when the markets are closed, for example the famous Ed Seykota, Peter Brandt, or Nicolas Darvas.
The justifications uttered by die-hard long-term disciples
Critical and large market downturns come along every once in a while at the end of a market cycle. This was for the last half a century approximately every 8-15 years, for example the dot.com bubble, the 08/09 financial crisis, and the current ’22 bear market.
The markets have an upward bias, financial advisers tell us. It’s true … you just have to hold long enough. They say this while showing us a chart spanning a century. “1,000$ put into XYZ in 1975, would be worth 200,000$ today” … 50 years later. But to get there, you have to be willing to be a masochist and to waste time. Lots of it.
Because you will have to sit through lengthy drawdowns, sometimes years, just to get back to where you already were. To compensate for such long and massive draw-downs, B&H ‘investors’ commonly recite a number of justifications:
I) “As long as I don’t sell, I haven’t really lost anything“
This is self-delusional. One look at their account value after a major bear market will tell them something else. Whatever the value of your stock is at a given time, whether you convert it to cash or not, is the exact amount of money you have. Holding on to it does not increase its value. Having 1000 shares of a stock that was at its highest point trading at $100 and riding it down to $40 in price is a 60% loss from what you once owned, if you convert to cash or not.
It’s as if you buy a house in a nice neighborhood, and then the neighborhood turns bad in the years after. The value you’ll be able to sell the house for has dropped massively. That money is gone … right now, you cannot sell it for what it was worth. It might come back, but not everybody has the luxury of young age to wait.
In the dotcom bubble, the Nasdaq Composite took 15 years to recover to old Highs. After the 08/09 financial crisis, the S&P 500 took 6 years to reach old price again. From 1905 to 1915, 1964 to 1982, and 2000 to 2012, the Dow Jones Industrials went sideways for decades. Such can happen again, locking money of ETF holders and widely diversified mutual funds out of profits in a “lost decade”.
That is, if you own market ETFs. If you are ‘investing’/speculating actively and pick stocks to hold forever, a stock might get back quicker. Might. But it might also give you a total and final loss, as I gave examples for above that were expected to be the ‘safe bets’ of the day.
II) “I just buy more when the price is down, I want to hold for two to three decades anyway“
Such is easy to say when you’re anything younger than 40 and have no attachments. But, we are all putting our money into the market for something. Retirement “nest eggs” to not have to work in old age, our children’s education, a car, the house at the lake, you name it.
When you’re 50 or over, this is not so easy anymore. See how you can fork over hundreds of thousands for your children’s education right now while the market has declined 50-70% and could take a decade to come back, or the “nest-egg” you have relied on to use right now to retire in a Mediterranean estate or to pay off a loan halves in value. You have a problem – a fat shiny one.
If you held through a major market decline – whether in a mutual fund, an ETF, or in individual stocks, you’ll have to work for another few years up to a decade or more, and instead of paying for your children’s education you’ll need to take a loan out, indebting yourself and likely your children.
Averaging down (buying into a declining market) at the wrong time can make things worse here. People have been conditioned in the late 90s and now the 2009 to 2022 bull decade that stocks only ever go up after pullbacks and the central banks are always there to support the stock market. You only have to do it wrong once and you amplify your losses, such as averaging down into bear market rallies in 2000, 2001, 2008, 2022, or you can go back as far as 1939 or 1930/31 and many times between. The more you lose, the longer you have to sit to break even, let alone be in a profit again.
Averaging down the way most people do is problematic, because it ties money up in a locked position where it can not be productive for years or decades to come. This can be worse than losing some capital.
III) “So what? I will just sell when I have the profits that I want, and when the market is high”
Unless you happen to be one of those that happen to require the money exactly when the markets are topping, odds are you won’t. Because … human psychology. We get greedy, fearful of missing out on more profits, and unless you have trained yourself for years in emotional discipline, you are very likely to make the wrong decision at the wrong time. Amateurs underestimate the knowledge it takes to spot market tops, and the boom and bust cycles of amateur wealth repeat again and again in history.
How will you know when you should take profits, just before retirement? How will you know when the right time will be just before the market rolls over, and not hope that it will not run up another few years? You won’t … because if you did have that skill you wouldn’t be a ‘long-term investor’ in the first place. You wouldn’t have ridden those market downturns to the bottom your whole life if you know how to time market tops.
As the famous physicist Richard Feynman said, “The first principle is that you must not fool yourself, and you are the easiest person to fool”.
IV) I am holding my stocks for yield income, the price does not matter
But price does matter. Imagine you buy 20,000$ worth of Coca Cola at $60.6 a share (i.e. 330 shares), and you get paid a dividend yield of 2.9%, about 145$, a quarter without tax.
Then the price of the stock drops to $50. Now, you have in reality net lost 3350$ (-10.6$ *330 shares, plus 145$ yield income) – before tax. Just because you get cash on hand while the loss on the stock is “on paper”, this is very real as your account balance will tell you. If the stock stagnates there for years or declines further, you will sit at a net loss for a long time.
Now, this does not need to happen, price may also rise or stay more or less stable … but again, there are no clairvoyants in the stock market. You just cannot know what will happen, you can only prepare for what might happen. If you do not control risk, there is no guarantee whatsoever that whenever the time comes when you need to sell your Coca Cola shares, price will be where you bought it or above.
Profitability from income investing always needs to be adjusted to capital a-/depreciation, income tax, etc. If you don’t pay attention to this, if you are ignoring reality, you are fooling yourself.
V) I am sufficiently diversified for any market environment
The more ‘diverse’ a portfolio is (e.g. 15, 20 or 20 stocks or more) the more average it becomes, waxing and waning with the general market. The more different stocks one buys, the higher the chance becomes that one selects stocks that are more average performers, diluting performance of the better holdings by forcing capital away from them and into less stellar performers.
Wide diversification is merely a ‘hedge’ against proper selection rules, having proper entry & exit rules, and real risk management. A hedge that dilutes profitability in bull markets and allows you the possibility of making mistakes and not having to admit them in a bear market … for a price.
If someone, in a bull market, buys 15 stocks and 8 of them do not make money or worse, lose money, the other ones will “make up for that” – so he argues. But what if he bought the 15, and then proceed to kick out the bad 8 and put the money to work in the good ones? This would always keep his money at its most productive and growth-oriented state.
In a bear market, diversification can help keep portfolio draw-downs less severe. Owning less volatile companies in the portfolio that are more of a defensive nature, next to holding on more volatile stocks such as high-tech, dampens the impact of the usually more bitter pullbacks of the latter. This is a widespread tactic utilized by large mutual funds. But the question arises, are you a mutual fund that is so big it can’t just enter/exit the market at will? Why not just get out altogether, and have minimal or no draw-down whatsoever, as compared to trying to mitigate a draw-down that is unnecessary in the first place?
Diversification is touted as a risk management strategy, but in reality is is merely born out of the fact that the investor does not really know how to exit hostile markets, time purchases, to deal with mistakes and cap losing holdings swiftly, and to select outperforming stocks. All this can be learned … with a little effort.
Concluding
Not a good picture for the B&H long-term ‘investor’…
In the 08/09 financial crisis, the S&P 500 shaved off 57%, and countless people’s retirement savings evaporated – either for many years for holders, or terminally for capitulation sellers at the bottom. In the dot.com bubble the Nasdaq Composite lost 78% of its value. We will see how deep this 2022 bear will dive.
Then of course there is the question of why you should ride a market downturn … the answer is as simple as it is offensive: because long term ‘investors’ don’t know how to time market tops and bottoms. In fact, many will pretend that it’s impossible to time them, ignorant of those who are achieving the same feat year in, year out. Being in the market without managing risk and without a way of timing the market is akin to gambling.
Fortunately there is a way around this – grab the fishing pole, and learn how to read the health of the market, and when to get in and out. This does not require you to spend every waking hour at your computer reading charts and placing orders. There are plenty of wealthy market speculators and traders that work only on end-of-day market data in the evenings, or on the weekends.
