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Opportunity Investing: The Myth of Buy and Hold

What do the companies Radio Corporation of America (RCA), Cisco, General Motors (GM), Trans World Airlines (TWA), Admiral, and Pan American Airways (Pan Am), have in common? These are or were significant American, for the most part New York Stock Exchange listed, corporations that have, in years past, risen to and then fallen from grace. Shares of Cisco, for example, rose from a price of 4 in 1992 to 82 in early 2000 before falling back to 8 by the end of 2004. GM, once the granddaddy of all corporations and the largest employer in the country? Priced at 11 at the bottom of the great 1973–1974 bear market, GM recovered to a price of 94 at the start of 2000, before declining to 31 three years later, to lower still and near bankruptcy by the fourth quarter of 2005. Wal-Mart, with more than 1.1 million U.S. employees, has—of course—supplanted GM as the nation’s leading private employer.

RCA, a pioneer in home radios and radio communication during the 1920s, rose from a price of 11 in the mid-1920s to 114 by September 1929 before plummeting to 3 in 1932. Admiral, a hot television issue in the 1960s, met a similar fate—and never did recover. TWA and Pan Am, once investor favorites, both failed to survive shakeouts in the airline industry. The drug industry has generally been regarded as one of the more consistent investment sectors for investors, but this has not prevented Merck’s roller coaster ride from 6 to 72 and down to 28. Another major M, Merrill Lynch, has seen its price range from 6 to 91 and then back to 26, like Merck within just one decade.

Such ups and downs are not limited to individual securities. The NASDAQ Composite of more than 3,500 issues rose from a price level of approximately 230 in 1984 to 5133 in 2000, before falling to 1108 at the bear market low in 2002. Even the more venerable Standard & Poor’s 500 Index has recently given up as much as 49.7%, declining from 1,527.46 (2000) to 768.63 (2002).

The point of all this is simply that, regardless of what Wall Street and the mutual fund industry would have you believe, there are considerable risks to buying and holding stocks, even for long-term investors, and especially for investors who may need to draw on their assets during periods in which the stock market is showing significant cyclical weakness (for example, during the 1930s, 1973–1974, and more recently, between 2000 and early 2005).

Moreover, buy and hold strategies, which actually worked well during the 1980s and 1990s, the two strongest back–to-back decades in history, are not as likely to work as well in the foreseeable future. The economist Paul Krugman, writing in The New York Times, February 1, 2005, observed that whereas annual economic growth in the United States averaged 3.4% over the previous 75 years, it is likely to average only 1.9% between 2005 and 2080. Inasmuch as the progress of stock prices tends to reflect economic growth, investors who limit themselves to just the U.S. stock market may be placing themselves in a position from which it will be difficult to achieve the rates of capital growth required for expenses later in life.

Variable Rates of Return from Stocks

Figure 1-1 illustrates the variability in the performance of the stock market over the 75-year period of 1930 through 2004.

Figure 1.1

Figure 1-1 Strong decades tend to alternate with weaker investment decades.
As a general rule, rates of gain from stock ownership tend to fluctuate, decade by decade, with strong decades generally alternating with weaker decades. The favorable two-decade period from 1980 to 1999 was unusually long in this regard. The weakness between 2000 and 2005 represented the long period required by the stock market to readjust down to more normal valuations following the speculative excesses of the previous two decades.

Investor expectations of the stock market tend to follow rather than lead significant changes in the stock market climate. For example, if investors were "irrationally exuberant" during the 1920s (as Chairman Alan Greenspan of the Federal Reserve said they were during the 1990s), they became extremely cautious following the stock market crash of 1929—a caution fed by the great depression and by the fact that stocks did not do much more than break even during the 1930s. Stocks were priced to reflect the general pessimism, with "riskier" stock dividend yields higher than prevailing bond interest payouts.

Investors remained cautious into the 1940s, which did show marked improvements in the behavior of the stock market, with annual rates of return from stocks increasing to 9.2% for the decade, roughly average for the stock market during the twentieth century, and increasing still further to 19.4% during the 1950s.

Such growth rates helped to foster more optimistic expectations of the stock market—this was the period of front-end, multiyear, mutual fund purchase contracts; high entry commissions into load mutual funds; and a dramatic increase in the number of American families holding shares. It should not have been surprising then that bear markets developed relatively early during the 1960s—a short but serious bear market during 1962, another during 1966, and another yet as the decade drew to a close. As a whole, however, stocks were profitable during the 1960s.

Stock market instability did extend from the start of a bear market at the end of 1968 into the 1970s, with an ongoing bear market ranging into May 1970 and stocks declining between 1973 and 1974 (and again in 1977). These periods favored stock "traders" as opposed to long-term stock investors. And then came those two glorious decades, the 1980s and the 1990s!

The confluence of developing technologies, the passing of the depression generation, the end of the cold war, economic growth, falling interest rates, and rising speculation resulted in consistently rising stock prices (only occasionally interrupted by intermediate market declines). These gains were fueled by increasing speculation and by a general belief that rising stock prices were going to be forever. By the peak of the bull market in 2000, stocks in the Standard & Poor’s 500 Index were, on average, yielding less than 1% in dividends and were selling at $46 per share for every dollar of company profits and at nearly $6 per share for every dollar of company assets—all told, at the highest ratios of price to measures of actual share values since the early 1930s.

And then, in March 2000, reality returned.

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