One of our SCT Members emailed me on Sunday asking for my thoughts on HPQ (Hewlett Packard) thinking it might be a good buy opportunity.  Turns out, I was also looking at HPQ last week.  I like it too.

Looking at the above chart, the lower, upwards sloping trend line is a monthly trend line.  That trend line and the 200 day moving average (yellow line) will provide considerable resistance.  If price can eclipse and move above these resistance areas, then price should go higher.

A quick trade would be to buy now and take profits at the resistance area.  I would probably opt for a longer time horizon.  The high price on Friday tagged the low made in August, 2004 and then traded lower from there in to the close.  If we can close above 16.80 then break above the two big resistance areas, our next level to watch is just below 22.50.

Hope that helps.

“[Warren Buffet] sticks to his rules, and never strays”. -Liz Clayman -Fox Business

I’m sure you’ve heard me talk about the need to have a framework of rules to follow. It’s just nice to be backed up by the greatest investor of our generation.

This is one of the biggest mistakes average investors make. They have no rules.

Without rules, individual investors are heavily influenced by emotion when making investment decisions. For the hundredth time: emotion is kryptonite for investors.

How do you know what stock to buy? Do you listen entirely to your advisor? Do you follow the latest pundit’s “top stock picks”? And if so, how do you know you’re buying at a good price?

Do you have a price target in mind? And if so, what happens if you hit that price, and the stock just keeps going higher?

Most importantly, what if the stock starts to fall? When are you going to get out?

Without rules, investors are like a captain without a compass. There’s no direction. You have no GPS. You're staring at a sky with no stars. And somehow you're trying to sail in the right direction.

With a proven set of rules, you can eliminate, or at least minimize the damaging effect emotion has on your decision making.

When we purchase a stock, we have rules in place, so every move is decided ahead of time. We know the scenarios that will cause us to sell to avoid further losses if the stock begins to fall.  We know when to let the market “breathe” and hold on through periods of minor corrections. And we know what will cause us to sell to capture profits.

We have no questions. We have rules, we stick to them, and we never stray. It works for Warren Buffet, it works for us, it’ll work for you too.

If you haven’t yet, you can check out the new investor training to see the rules that we’ve used to beat the market by 57% the last five years.

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Alternatives to Buy & Hold

If you’ve read the first two posts in this series (Part I, Part II), then you’ll remember we’ve come to the conclusions that:

1. Buy & hold is not a risk averse strategy as brokerages would like us to believe. In fact we are risking 50% and more of our money (as we’ve seen the last 10 years)
2. A few of the primary reasons buy & hold is so prevalent is misplaced credit for 80‘s and 90‘s gains, and that it’s a self serving strategy for big brokerages

In the final post of this series, we need to examine what alternatives there are to following the ubiquitous non-strategy of buy & hold. In order to do that, I think we need to first identify the biggest weaknesses of buy and hold.

Buy & Hold's Biggest Weakness

As we’ve discussed, I believe the most important factor in any investment strategy is protection. I’m not the only one who holds this to be true.  You should also remember from the first two posts, that the most striking weakness of buy & hold is a severe lack of risk management.

Buy & hold relies on diversification and periodic sector rotation to mitigate the risk of bear markets. Yet, these practices provide little protection from significant bear markets where virtually all equity classes will fall. Again, I’m not arguing against these practices, as I believe they have value. However, I AM saying they are largely insufficient as a form of protection.

So... our number one priority as investors should be protection. The number one weakness of buy & hold is a lack of protection. Therefore, that’s exactly where we’ll look to improve with our alternative strategy.

What can we do to better protect against heavy losses and significant bear markets?

Aside from a few options strategies, SELLING is the only way to protect against these types of losses. Another problem, however, is the lack of discussion regarding selling. (This can obviously be attributed to the industries love affair with buying and holding).

What solutions do we have that help us to know when to sell?

Stop Loss?

One of the simplest, and most used strategies is the stop-loss. If you don’t know, a stop-loss is simply selling after a pre-set percentage loss. So, if your stock drops 8% (ex.) from your purchase price, you sell, not matter what.  Thereby limiting your losses.

A trailing stop is used to capture profits. You just keep moving your stop higher so it’s always, 15% (ex.) below price. So, if you’ve gained 50%, then the stock drops 15% from that high, you’re out with a nice 35% gain. This is preferable to a “target price” as you’re allowing yourself to ride out your profits, but protecting yourself from heavy losses.  However, the a trailing stop is very rigid and doesn't take market activity into account, so you will often still miss out on potential profits (see chart below).  Still, it allows the market some room to breathe, where choosing a "target price" allows for none.

For example, how great would you have felt 7 years ago if your broker had you buy Apple at 160, with a target price of 192 in 18 months. You hit 192 and sell for a fantastic 60% gain... only to watch Apple go up another 220% the next three years!

I’m not a huge fan of a stop-loss or trailing stops. They’re very limiting, and don’t take other market activity and indicators into account. They’re a simple, and basic way to limit losses. However, I feel like using a stop-loss is leaps and bounds better than having ZERO strategy for protecting against heavy losses.

Stop Loss on Steroids

What I prefer, and what we use at Smart Chart Trading, is like a stop-loss on steroids. It is based more on what we’ll call “price events” relative to our “framework” around price. We don’t pick a predetermined price point or percentage loss to sell at. Our sell strategy is dynamic and adjusts as the market changes. We don’t pick a point, or know exactly at what price we will sell, but, we know the exact events that will trigger a sell.

These events occur around critical price areas. Yes! There are critical price areas. Only a short time reviewing price activity around these areas will convince you of this fact.

So, we use these indicators and price areas to pre-determine the parameters that tell us when risk is too high and selling is appropriate. Which allows us to let the market breathe, but also keep losses at an absolute minimum.

For example, our SCT Model, trading off of the SPY (S&P 500 ETF) and has averaged only 5% losses on these types of loss minimizing trades. (The model averages 47% gains on correct trades by the way). So we average a far lower loss than a standard 8% - 12% stop loss.

Buying & Holding might be OK for a pension fund or endowment as they run in perpetuity. However, an individual doesn’t have this luxury. An individual has an “investment horizon” to deal with. We can’t afford to get stuck in a 17 year secular bear market. We can’t afford to buy and HOPE that our retirement is timed perfectly with a bull market. The math just won’t work out, especially as one gets closer to their “investment horizon”.

So... is there an alternative to buying and holding?

Obviously, I think so. And I believe the alternative can actually significantly outperform the market. And outperform the market with significantly less risk. (check our performance history here).

What do you think?

I don't like JACK for a few reasons.

1. Price was essentially range bound and sideways for 2009, 2010, and 2011.

In fact, price was so confined by this range, and traded so flat through this period, that the three moving averages displayed (20w, 50w, 80w) were right on top of one another for about two years.

2. JACK has had a nice run up for 2012, however, price is nowhere near a good support level.

You're a long way from where we would like to set our risk.  Remember, our primary focus needs to be managing risk and purchasing this stock means you're risking at least 12% - 15%.  I'd rather purchase at a point where I can apply an exit strategy with less risk.

3. Finally, JACK hasn't provided any more gain vs the S&P 500 since the low in 2009.

Why own JACK when you could own 500 companies that are performing just as well?  Owning 500 companies carries less risk than owning 1 that hasn't performed any better than the composite of 500.

This doesn't mean it won't go higher from here.  However, I wouldn't be a buyer at these levels.  I do like their commercials though.

If you have a chart or a company you'd like reviewed, just shoot me an email or use the contact page on the site.

Why Buy & Hold Became so Prevalent

So we left off concluding that buy and hold is NOT the strategy with the least risk and most long term profitability as Wall Street would love us to believe (and spends billions in advertising to convince us).  Personally, I don’t think buy and hold is even a strategy. If you haven’t read the first post in this series you can find it here.

Moving on... we now have to examine WHY buy and hold has become so prevalent.

Prudent Thinking
As defined benefit plans (pensions) gave way to defined contribution plans around the 1970’s, employees were almost forced into the stock market to fund their retirement years.  More and more people were in charge of investing and growing their savings to fund retirement.

Around this same time buy and hold was being promoted as a safe and prudent investment strategy for the average investor merely looking for sustained conservative gains. Buy and hold goes right in line with middle class American values of optimism, practicality, and natural aversion to risk.

It was anathema to the over leveraged get rich quick thinking that had caused the crash of ’29 and made millions of Americans wary of the market.

Unfortunate Timing
Right when buy and hold was gaining momentum as a “safe and effective long term strategy” during the late 70’s and early 80’s, stock valuations were at extreme lows. So you had an entire generation, and an entire country, “buying and forgetting”. Fast forward 15 - 20 years, and the same investors have experienced safe, sustained growth.

Then the shit hit the fan. It had been a very long time since a major correction and many investors had never experienced one in their investment lifetime until 2001. Then it happened again a few years later in 2008. Pensions are now upside down, and middle class America has been taken to the cleaners.

Looking back it’s clear that the growth from ’83 - ’01 had zero to do with the strategy of buy and hold and more to do with valuations. But don’t tell that to buy and hold advocates who had built their retirement’s on the strategy. Predictably, buy and hold received the credit, and ever since it has been embedded in the industry, as well as in the average investors mind.

Add that to the fact that most individual investors who attempt to beat the market fair extremely poorly in their attempts, due in large part because they try to “time” the market with no clear plan, or rules-based strategy. Instead, these attempts are pure guesswork, and more often than not, dictated by emotion.

With no real expertise, and with no real strategy to make these types of decisions why would so many people try to “outsmart” the market? I’d say it’s because they weren’t content to sit through the heavy losses you’re required to sit through if you are truly buying and HOLDING. But again, with a lack of proven strategies to follow, attempting to time the market is a recipe for disaster.

What’s good for the goose not so good for the gander
The final reason why buy and hold has become so prevalent?  Money.

Not money for you and me, since I believe we can do much better than buy and hold. But profits for the big brokerage houses.

Buy and hold is a self serving model for brokerages.

Most advisors are trained to follow Modern Portfolio Theory (MPT). MPT is essentially buy and hold using diversification and periodic sector rotation to try and mitigate the risk of never selling.  This strategy is based on the belief that regardless of valuations, stocks are always a good investment.  Were stocks a good investment in 2000/2001? Were stocks a good investment in 2008? NO!  Yet, the stock selling industry would have nothing to sell when valuations or risk is too high, so it’s very convenient that their default strategy keeps you invested in equities at all times, regardless of valuations or risk.

So buy and hold fits PERFECTLY with the big brokerages goals. It seems like a safe strategy to investors due to it’s simplicity and conservative long term focus. It keeps you in the market, and keeps you buying.

The problem is it only takes a quick analysis of this strategy to see that it’s a weak strategy at best (and I actually don’t even consider it a strategy). “Buy and do nothing” is not much of a strategy as far as I’m concerned. You’re basically accepting 50% and higher potential losses, and simply HOPING that your retirement doesn’t come around during a bear cycle.

But most importantly, it’s greatest weakness lies in what should be an investors greatest focus: risk management.

Most advisors attempt to mitigate the risk of buy and hold by diversifying and periodically rebalancing our assets. As we discussed in the previous post, these practices are completely insufficient forms of protection.

Conclusion?
So, reviewing our original questions. I believe buy and hold is not a strategy with limited risk as Wall Street would love us to believe. I also believe we can significantly improve upon buy and hold’s long term profitability (I’ll tell you why in the next post).

We’ve identified at least a few of the factors that have made buy and hold so prevalent... faulty theories, misplaced credit for profits, and because it serves brokerages bottom line.

Now we need to find out what alternatives there are. Watch for the next post... Alternatives to Buy & Hold.

*This is not meant to be a comprehensive analysis on the contributing factors to the rise of buy and hold as a dominating long term investment strategy; but an overview on what I see as the rise and fall (in my opinion) of buy and hold as a legitmate strategy.

Buy and Hold... Buy and Hold... Buy and Hold... Buy and Hold...

A pattern that has repeated itself millions of times for millions of investors for decades.  But why?

Is this really the strategy with the least risk, and most long term profitability as Wall Street would have us believe?

Today, I want to examine this question. And if the answer is no, then why has it become so prevalent? And what are the alternatives?

For the purposes of this post, we’ll define “buy and hold” not as the general use of buying and holding any equity, fund, etc. But specifically as Wall Street’s use of buy and hold to buy a diversified portfolio of equities, bonds, mutual funds, etc and hold on for an indefinite amount of time... or forever.

The average individual investor relies heavily on his money manager for his or her investment decisions. After all, the average investor doesn’t have 40+ hours a week to devote to educating themselves on investing strategies, and analyzing stocks.

So we rely on our advisors. We trust (to some extent) the big brokerage houses the most as they’ve been around forever and have the most capital to invest in research and talent (as well as advertising), so we go with one of them.

Buy & Hold, Diversify, Rotate Sectors
Our money manager advises us on a buy and hold investment plan that incorporates a diversified portfolio with periods of sector rotation and asset allocation in order to manage risk.

But buy and hold means exactly that. We are buying, then holding on through every market cycle, good or bad, bull or bear. We’re simply buying a ticket for the roller coaster.

But we don’t want to hold on through severe bear markets. We want protection. So, like our broker advised, we diversify, we rotate sectors, and use asset allocation to manage or minimize the risk of bear markets.

But does this really protect us?
During severe, or prolonged bear markets, won’t virtually all stocks, and all sectors fall? Honestly, are we to believe that simply because we own a variety of companies that we’re somehow protected from bear markets?

How did that work out the last twelve years?

Diversification is not a complete form of protection.

If the big brokerage houses - who have so much money, and so many resources - if they truly “have the experience to guide you to retirement”, then why is it that the average investor fails miserably to even match the market? From ’88 - ’08 the average investors annual returns were 1/4 that of the market!  Granted, the individual investor takes some responsibility. But that’s what we pay our advisors for.

No other industry gets paid billions of dollars, for such a mediocre-poor product.

The average investor would be FAR BETTOR OFF by simply saving all the money they spend on advisor fees, and mutual fund loads and fees, and simply put their money into the S&P 500, or any other index. According to the statistics, they’d be making far more than they have been, and spending exponentially less on fees.

Diversification’s Failure to Protect
I have a number of friends who have MULTIPLE money managers working for them. Independently of each other. They all followed the same general buy and hold plus diversification strategy. One of my friends was on track to retire around 2002. Well, as you know, the market dropped 50%. Did his high-priced money managers and well diversified portfolio protect him from that 50% bear market? Not at all. He was forced to put off retirement for another 5 years. Instead of rolling out of bed at 8:30 for a tee time, he spent 5 more years waking up to an alarm at 5:00 in the morning to go to work.

Or another friend who again, had FIVE independent money managers. Each created a well diversified portfolio. How did that help him in 2008? He lost over 45% of his portfolio’s value.

In my humble opinion, diversification, along with sector rotation and asset allocation, are not effective, or complete forms of protection. We absolutely need another way to protect ourselves from significant bear markets and heavy losses.

If you weren’t already convinced of this through the experiences of your friends, the experiences of my friends I just shared, or the logical conclusion that the majority of stocks fall in bear markets, then look to your own experience and tell me if these tools have helped you to avoid the heavy losses experienced by so many in the early 2000’s and 2008.

I could go into more detail as to exactly why diversification, et al, are not complete forms of protection and their association (or origination) with Modern Portfolio Theory. But that can get technical, and I’d just be expanding the on premises I already made, and I’d like to move on as I’m sure you would.

Conclusion?
So... my conclusion is that diversification is not a complete form of protection.

Since diversification is the primary risk management tool for the brokerages who preach buy and hold, then I have to conclude that buy and hold is not a risk averse strategy. In fact, we are left risking 50% or more of our portfolios value with no other form of protection.

In addition, individual investors poor performance history - failing to even come close to matching the market - leads me to believe that there’s much more room for long-term profitability.

Therefore, to answer our original question... in my opinion, Wall Street’s version of buy and hold is not the strategy with the least risk and most long term profitability. At the very least, it does not provide sufficient protection from bear markets.

Since the answer is no... we now have to examine WHY it has become so prevalent.

It’s partly due to market activity that reinforced the strategy for an extended period of time, and partly due to big business and corporate greed.

Now, I hate to vilify big business as I’m a free market capitalist, but in this case, the answers lead to a pretty logical conclusion.

Look out for the next post in a few days...