Last week I talked about the real reason most investors get slaughtered in the stock market.
All complexities aside, investors simply don’t have the psychological strength to execute the “hold” portion of “buy-and-hold.”
It’s easy to hold stocks when they’re going up (as they do a majority of the time). It’s even easy to hold stocks through a routine 5% or 10% dip.
But when stocks are down 50%… 60%… 70%… even 80%… most investors cave to that gnawing feeling in our gut. It screams: “Enough is enough! Get me outta here! Give me my money back!”
As well-intentioned investors, we listen to our own fearful pleas. Essentially, we hit the panic button and run for cover. And cruelly, we usually reach our rock-bottom breaking point at just the worst possible moment – only after stocks have already fallen 50% or more, and just before they begin their long road to recovery.
As I said, it’s cruel!
But there IS a solution to this conundrum.
After all, buy-and-hold isn’t without merit. It’s just missing an important piece of the puzzle: capital preservation.
Think about Warren Buffet’s two rules for investing…
Rule #1: Never lose money.
Rule #2: Never forget rule #1.
Now, I take issue with Warren Buffett’s “never lose money” mantra, but only on a technicality. I think it’s impossible to invest in financial markets and, literally, “never lose money.” No one has a 100% perfect track record, not even Warren Buffett.
So I prefer to say: “Never lose all of your money.”
That’s what capital preservation is all about!
No matter what, you should act in a way that ensures you keep at least some of your money for tomorrow. No matter what, make certain you operate in a way that allows you to live to fight another day.
It’s as simple as that. Yet, many investors fail to fully embrace this – both in philosophy and practice. And the buy-and-hold doctrine completely fails investors when it comes to capital preservation.
I’m sorry… but telling me to just “buy and hold (and hope)”… telling me everything will be fine, as long as I close my eyes and ignore my account statements for 30 years or more… that just doesn’t cut it for me!
Simply put: buy-and-hold needs a safety valve.
The safety valve is all about capital preservation. It ensures we don’t lose all of our money. It ensures we aren’t faced with the tough decision to sell our portfolios when they’re down 80%, else hold on and hope a bit longer.
And the good news is there’s a simple way to do just that – to add a capital preservation component to buy-and-hold. Here’s one way to do it:
Rule #1: Buy-and-hold, but only if the stock market is above its 200-day average.
Rule #2: Sell stocks (move to cash), if the stock market is below its 200-day average.
It’s simple advice. So simple that I suspect a majority of investors will ignore it – either because it sounds too simple or because it’s boring.
But if you’re serious, truly serious, about capturing the long-run returns that stocks provide and preserving capital, then consider this.
If you had bought $100,000 worth of shares of the S&P 500 in 1965 and held through today, you could have earned a profit of nearly $2.2 million.
Notice I say “could have.”
Buy-and-hold suffered a 56% drawdown during the 2008 financial crisis. So earning that $2.2 million return would have required unshakable discipline to the buy-and-hold doctrine, something I’ve seen very few investors able to do.
I was working as a financial advisor at the time, so I can personally attest to the fact that most investors panicked and sold their stock holdings during this gut-wrenching period.
That’s why investors almost never earn the full buy-and-hold return even if, in theory, it’s available to them. Recall that while stocks have produced annual gains of 7.8% over the last 20 years… investors have earned just 2.1%.
And that’s why a capital preservation strategy is far superior. Anyone who had followed the two simple rules of capital preservation investing could have done a lot better in 2008. Get this…
The capital preservation strategy recommended moving to cash on December 28, 2007. And it recommended remaining in cash for the entire year of 2008!
So while the traditional buy-and-hold strategy suffered a maximum drawdown of 56% through the Great Financial Crisis, the capital preservation strategy was down just 13%, before moving to the safety of cash for the entire year.
Clearly, a capital preservation strategy saved hides in 2008. But it’s also saved investors from a number of wealth-destroying periods over the last 50 years.
Specifically, the capital preservation strategy earned a total return of $2,118,000 – just $72,000, or 3%, less than buy-and-hold – but suffered a maximum drawdown that was only half as severe as buy-and-hold’s!
Take a look…
Listen… I’ll take 97% of the market’s total return in exchange for a 50% risk reduction any day of the week – and you should too!
That’s what capital preservation is all about!
It’s about finding a way to participate in the stock market’s bullish bias… but only when it’s relatively safe to do so. And then, when the risks are too high, it’s about sitting safely on the sidelines, in cash.
I call this strategy “buy-and-hold-and-preserve.” And I’m convinced that it’s a far safer option than buy-and-hold.
To good profits,
Chief Investment Strategist, Dent Research