Buy And Hold, And Diversify

by: Cash-Centered Creep

Summary

Despite BuyandHold 2012's best efforts, trading still remains a major feature of the stock market.

By using the Rule of 20, it is possible to find stocks trading at an affordable price.

Buy and hold, but also remember the importance of diversification.

I am a buy-and-hold investor. This means that, once I pick a company to invest in, I will hold onto it with no intention of selling it. The only stock I ever recommended selling was Yum China (YUMC) after it spun off from Yum Brands (YUM), and the reasons for that recommendation can be read at this link without requiring further exegesis here. Otherwise, if I'm recommending a stock, I'm recommending it for the longest possible term.

Profile picture of Buyandhold 2012 The foremost preacher of buy-and-hold investing on Seeking Alpha.

Despite the rise of awareness in buy-and-hold investing - championed notoriously on this website by the estimable Buyandhold 2012 - the trading mentality remains hard-wired into many investor mindsets. Right now, with the market amidst its highest-ever levels - the S&P 500 (SPY) over 2,700, and the Dow Jones Industrial Average (DIA) over 24,700 - the notion that one can time the market and exit at an advantageous time is becoming more prevalent and this has led to investors becoming more engaged in active management of their investment portfolios.

This is a far cry from a decade ago, when the notion of investing in the stock market at all was seen as foolhardy. But that sentiment touched on the problematic aspect for investors that employ a buy-and-hold strategy - enduring stock market declines while remaining invested. Conversely, the temptation to revise one's approach and consider attempting to "time the market" with a view to cashing in and garnering a profit when the market is hitting a high, as it is now. In short, fear will dominate an investor's thinking near the bottom tick, whereas greed will dominate near the top.

Market Fear/Greed Cartoon Image from Shares Investment (Singapore)

This leads to active management of a portfolio, which is deleterious to the profit that you would wish to garner as the costs of trading - transaction fees, capital gains tax etc. - will eat into such profits, and those costs would not be incurred if you were to buy and hold instead. And since "timing the market" rarely works out well and leads to too much trading, underperformance usually results.

With buy-and-hold, by contrast, you can buy a stock that you have researched and allow time in the market - as opposed to timing the market - to benefit you. The one aspect that does need to be considered with respect to timing is what your entry price is, which leads to consideration of fair value. Generally, as Bloomberg's Michael P. Regan explains, fair value in the stock market can be determined by the Rule of 20:

A measure of stock valuations called the Rule of 20 states that the stock market is fairly valued when the sum of the average price-earnings ratio and the rate of inflation is equal to 20. Above that level, stocks begin to get expensive; below it, they're bargains.

While each stock needs to be considered within its own set of circumstances, the Rule of 20 is a handy way of whittling down which stocks are good value for money. By this criteria, online retail giant Amazon (AMZN), with its P/E of 265.49, is clearly overvalued. By contrast, insurance firm Aflac (AFL), with a P/E of 13.00, is clearly undervalued. Furthermore, as Aflac is a dividend aristocrat - a stock that has paid shareholders consecutively rising dividends to shareholders since 1983 - it is an excellent stock choice to buy and hold.

Ronald Read Image of Ronald Read from CNN

However, buying and holding one great stock like Aflac is not enough. For peace of mind, it is sensible to diversify the portfolio. This will assure you that, should one stock fail, you will still have a profitable portfolio working for you. This was the strategy employed by Ronald Read, the gas station attendant and janitor who built a 95-stock portfolio worth $8 million at the time of his death in 2014. And it served Read well, as General Motors (GM) and Lehman Brothers Holdings Ltd. (LEH) both went bankrupt, the losses he incurred from these investments was more than offset by his holdings in firms such as Bank of America (BAC), Deere & Company (DE), Johnson & Johnson (JNJ), and the Procter & Gamble Company (PG).

How much should one diversify? That really is a matter of individual preference. Jim Cramer reckons that an investor should have no fewer than five to ensure adequate diversification, as:

You will be overexposed to one industry and an unexpected negative can do some real damage...Diversification is the single most important concept in investing...It's the key to avoiding enormous losses and making sure you can weather a storm.

I have no argument with Cramer's advice on the necessity of diversification. However, his limit on diversification is less sound. Cramer believes that investors should have no more than ten stocks in their portfolio to ensure that they can cope with ongoing monitoring of their investments.

Any more than ten and you'll have to spend too much time doing homework...You've got to spend at least a couple of hours a week on this kind of research...

For a dividend investor, this would be tantamount to having 10-20% of annual income in jeopardy where a stock to fail. It certainly was not an issue for Ronald Read, who died a multi-millionaire. Nor, to take a contemporary example, has it been an issue for Jason Fieber, the former automotive service advisor who has built a 110-stock portfolio that, as of June 5, 2018, is worth $356,215.21 and enabled Fieber to retire at the age of 33. Unlike Read, Fieber does take more active management of his portfolio, though he sells rarely. But contra Cramer, he has had no trouble managing such a gargantuan portfolio.

Jason Fieber

Image of Jason Fieber from his website, Mr. Free At 33

What Read and Fieber both show is that, a buy and hold strategy, twinned with portfolio diversification, can work. Read never sold a single stock - General Motors and Lehman Brothers remained in the portfolio until the bitter end, and he still came out on top. Fieber retired earlier than most people could ever dream of doing. In summary, the key takeaway from the examples of these two gentlemen is: buy, hold, and diversify.

DISCLAIMER: The author is not a financial professional and accepts no responsibility for any investment decisions a reader makes. This article is presented for information purposes only. Furthermore, the figures cited are the product of the author's own research and may differ from those of other analysts. Always do your own due diligence when researching prospective investments.

Disclosure: I/we 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.