Catching up with some old issues of Worth, I was struck by this September cover line: Why Warren Buffett Is Wrong About Stocks. The article, by Adam Hanft, was entitled, Mr. Buffett, Your Time Is Up. Worth summarized it this way: ‘Buy-and-hold investing was never as smart as Warren Buffett made it look. Today the strategy may even prove dangerous to your portfolio.’
Some interesting points were made, but what struck me was the elephant in the room that was never even mentioned, unless I missed it – the principal motive for buying-and-holding: taxes.
If you invest within the shelter of a tax-deferred account, and if you believe you have the analytical talent to identify and then switch from overvalued companies into the stocks of companies selling for less than they’re worth – more power to you. It’s a tough game, but highly rewarding if you can actually do it. And other than the frictional cost of what can now be very modest commissions, there’s no great handicap in trying. Likewise, if you invest through mutual funds within a tax-sheltered account and think you can ‘time’ the market, jumping out when it’s peaking, jumping back in when it’s dropped – more power still. It may be an even tougher game; but if you invest in no-load index funds, with no surrender fees, it could work. (The problem is that you run the risk of missing terrific, explosive rises in the market. The market seemed overvalued by many measures throughout most of its rise from 2000 to 11,000. Would you have wanted to sit it all out?)
In a tax-deferred world of deep-discount commissions, Worth is right: buy-and-hold is no special virtue. If you can switch from a company whose stock has gotten ahead of itself into another whose stock represents fair (or even great) value, there’s no reason not to.
But that’s not the world Buffett or many of the rest of us live in. The world we live in clips 20% of your profit if you hold a stock for a year and a day, perhaps as much as 40% or more, between federal and local income tax, if you take profits in under a year.
So look at Warren Buffett, who has managed to compound his (and his shareholders’) money at something like 24% a year since 1965. A dollar compounding at that rate grows to $2,307 in 36 years. Should Worth have mentioned someplace that – had he earned the very same 24% each year but switched his holdings each year after they went long-term, subjecting his gains to, say, 23% tax (federal plus local) – that same dollar, with that same spectacular 24% pre-tax return, would have grown to ‘only’ $447?
One way, $2,307,000 for each $1,000 invested; the other, $447,000. It’s not a trivial difference. You pay a high price to trade rather than buy and hold.
I’m not saying it’s never smart to sell an overvalued stock.
(And I’m not saying Warren Buffett’s return was as simple as buying and holding a few stocks that just went up 24% a year – he has had the advantage of ‘float’ from his insurance operations that, in effect, gave him a zero, or even sub-zero, cost of borrowing to invest ‘on margin,’ as it were, legally and prudently leveraging up his returns with other people’s money. The stocks he owned didn’t have to go up 24% a year to achieve that kind of return, because of the leverage he could employ.)
Failing to sell when a stock gets swept up to irrational heights is a mistake I’ve made myself all too often, and the reason has always been the same: tax-phobia. Look at the people who couldn’t bear to sell Priceline at $150, or Amazon at $250, because of the tax bite. At $3.90 and $7.80 a year or so later, they don’t have to worry about the tax bite; only the self-recrimination.
So you can’t buy and hold blindly.
But so long as capital gains remain taxable, buying-and-holding gives you a tremendous leg up that the Worth piece, though thought-provoking, forgot to mention.
Quote of the Day
Money often costs too much.~Ralph Waldo Emerson
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