You're at your annual holiday party.
A fellow reveler brings up the topic of the stock market. He says he's not concerned about the recent market volatility because he's a "buy-and-hold" investor.
Now, I don't want you to start any trouble, but you might politely remind him of two letters: G and E, as in General Electric (NYSE: GE).
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You see, the market doesn't care how fantastic your stocks are. If you blindly believe that in the long run your favorite stock will appreciate, just think about GE.
This company is the bluest of blue-chips. It's iconic. We are talking about the firm founded by the likes of Thomas Edison and J.P. Morgan in 1892. A company responsible for making everything to jet engines to refrigerators.
While the company's troubles are well-known today, it still generated $121.6 billion in sales last year. But the truth of the matter is that this stock has been a "problem child" for quite some time.
Let's see what "buy and hold" investors were treated to for being so loyal to the stock over the years...
That's right... after 23 years the stock has gone exactly nowhere. And remember, we're not talking about some fly-by-night company here.
Sure, there were times investors could have hopped off the GE train and booked a tidy profit. But those who blindly held on were treated to one hell of a ride. That's mainly because investment decisions are usually controlled by emotion, not logic. We tend to be overly defensive about the stocks we own. And a good many individual investors justified their owning GE over the years by reminding themselves of the company's storied history, it's reputation, etc.
It's usually only when you're out of a position that you see things in technicolor. (Where is Mr. Spock when we need him!?)
You'll likely hear plenty of commentators talk about how "this is the bottom" for GE. And maybe they're right. But they also said the same thing this spring after shares tumbled from around $18 to down around $12, a 30% haircut -- only to watch shares continue to drift to less than $7 a share.
Why Buy-And-Hold Isn't All It's Cracked Up To Be
I know I sound like the proverbial broken record when I talk about this topic. But the fact of the matter is that I worry more about the risks investors are taking than anything else.
Here's what I mean...
Buying a stock should always involve some consideration of value. Whether it's robust cash flow or even something as simple as a low P/E multiple, it's always important to have an educated guess about what your investment will be worth down the road. Unfortunately, many buy-and-hold investors ignore value. That's because they are fixated on investing for the long-term, come hell or high water.
I literally cringe when I hear about someone losing money in the market. That's because it's usually due to misunderstood philosophies, a nonchalant attitude, or simply ignoring the risks they are taking.
But don't get me wrong. As much as I bash buy-and-hold investing, it can work... if you follow some simple rules. You still have to have a sell signal in place to preserve capital.
Here's the reality... Followers of the buy-and-hold strategy are accepting astronomical risks without realizing it. In the case of GE, they lost the most valuable and irreplaceable thing when it comes to investing and building wealth: time. These investors seem to accept these risks -- the risk of losing 23 years of time -- with nothing to show for it.
There's A Better Way
Imagine if these "buy-and-hold" investors had followed a simple 25% trailing stop-loss strategy. From 1996 until GE's first 25%-plus pullback in 1998, they would have locked in a triple-digit return... and avoided the dot-com bubble.
The reason I talk so much about risk management and cutting losers short is that I know how hard it can be. It's tough to sell a stock for a loss. Most traders would rather hold onto a loser than admit they are wrong (which is what you are doing when you cut a loser). The thinking is always, "I'll get out when I'm back to even."
Your pride and ego take a hit when you sell a loser. But you have to get that sort of thinking out of your head if you want to be successful in the stock market. Once you realize that making money is more important than your pride or ego, you will be on your way to becoming a more successful investor.
Don't let small losers turn into big losers. Learn to accept -- and feel OK about -- cutting a loser from your portfolio. Because it's not a loss... it's a victory against avoiding a massive loss.