If I were only allowed two words to describe the most necessary ingredient of a successful investing strategy, it would be this: "Know yourself." Thinking that you are one type of investor when, in fact, you are another, is one of the most dangerous things that you can do. If you falsely believe that you can tolerate the wild swings of the stock market, you are going to self-destruct when the stock market tumbles of 2008 and 2009 come around. Along these lines, it can be dangerous to style oneself as a long-term investor when nothing could be further from the truth.
Over the course of the past year, I have heard from investors who have decided to pay full value for shares of excellent companies like Colgate-Palmolive (NYSE:CL) and Kimberly-Clark (NYSE:KMB) with the belief that a holding period of fifteen to twenty years will deliver stellar returns. This can be a sound strategy, provided that you actually follow through and hold for the long term. If you buy the stock of a company without any margin of safety built into the stock price and decide to sell in a couple years when interest rates rise, the economy recovers, or growth stocks soar, then you could possibly be setting yourself up for disappointment.
For an example, I wanted to take a look at the history of a company closely associated with long-term investing: The Coca-Cola Company (NYSE:KO). Before the bear market of 1973-1974 hit, shares of Coke were trading around 20-27x earnings during the first two years of the 1970s. What would have happened if a hypothetical investor bought $10,000 worth of Coke stock at the average price point in 1972? He would have experienced the see-saw of steep drops and sharp gains that would have produced this result: with dividends reinvested, the investor would have woken up in March 1982 with $10,000 in his account.
That's right. Over a ten-year period of reinvesting dividends in one of the greatest companies in the world, the investor would have achieved 0% returns (and he would have actually lost money if you factor in inflation). Of course, a great reward awaited the investor who held on to Coke throughout the 1980s: the investment quadrupled in terms of total returns between 1982 and 1988.
If we look at the 1972 to 1988 period holistically, the thought of owning a stock that quadruples over a sixteen-year period may interest us. But that statistic is only useful if taken in context. A decade is a long time. For some people, that might represent 25% of an investment lifetime. Some folks may not have the patience to hold shares of a company for an entire decade that does not increase wealth. It takes a tremendous amount of patience to weather such a storm.
Before labeling yourself a long-term investor, I think it could be worthwhile to pose the following question for self-examination: What are the limits of my patience with an investment? It's no sin to answer the question, "There's no way I would hold on to a stock that treaded water over the course of a decade." It only becomes problematic when you make an investment with the belief that you can wait out the fluctuations of Mr. Market and the business cycle, when in fact, that doesn't suit your temperament.
I have a three-pronged personal solution to address the "dead investment for a decade" scenario.
The first part of my solution is diversification. If Procter & Gamble (NYSE:PG) represented 50% of my net worth, and the stock didn't appreciate over the course of ten years, I'd be at a high risk of dumping the stock and abandoning my strategy. But if the company represented 7% or less of my net worth, it's much easier to remain calm and say, "The profits from shaving razors and detergent are still growing. The rewards will be reaped eventually."
The second part of my solution is this: an investment in a company is not a fixed thing. You can always add to an investment. While the returns of Coke may have been nothing between 1972 and 1982, there were some great opportunities to add to a Coke position in 1974, 1977, and 1979 that would have greatly enhanced the performance of the stock when March 1982 came around. Selectively adding to an investment during drops can be a great way to boost returns.
And the third part of my solution is this: dividend growth. One of my famous quotes from John Neff, the gentleman who used to run the Vanguard Windsor Fund, is this: "Dividends allow you to snack on hors d'oeuvres before the main dish arrives." If I'm going to have to be patient for a while, I might as well receive growing amounts of income while waiting for the expected price growth to arrive. It would be much more doable for me to tolerate ten years of stagnation if I knew that I was receiving a check from the corporation every three months that grows each year.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.