Thursday, August 13, 2009

Diamonds Might Be Forever, but Few Stocks Are

I dislike most stock-trading strategies, especially day trading, which I liken to betting on where a butterfly is going and when it's going to get there. The stock market should be simply about investing, because investing is about the noble endeavor of turning human capital into financial capital, and that requires years of commitment.

Yet that doesn't mean you have to hold a stock forever. Nothing is forever -- not you, not me, not even the Sun. Change is constant. Consider that more than half of the 30 Dow Jones Industrial Average stocks weren't components before 1991, and six of the stocks became components in 2004 or later.

Many investors speak of durable quality and staying power when they invest for the long term, but more often than not, they overestimate both items. A decade ago, for example, an investor could have persuasively made an argument for the durable quality and staying power of former DJIA members Eastman Kodak (NYSE: EK), American International Group (NYSE: AIG), and General Motors.

The history of the DJIA in particular and the stock market in general suggests that selling is not a consideration to take lightly, given the ephemeral nature of stocks' staying power. So when should an investor consider selling? Werner DeBondt and Richard Thaler noted in a Journal of Finance article titled "Does the Market Overreact?" that three years is a relevant time frame, based on Ben Graham's contention that the interval for a substantial undervaluation to correct itself was one-and-a-half to two-and-a-half years.

Speaking from a value perspective, I prefer a longer time frame, though -- one based on the ebb and flow of the business cycle. From 1945 through 2001, there were 10 business cycles, according to the National Bureau of Economic Research. The average time it took to get from the previous trough to peak was 57 months. I'm willing to give a company five years to right itself.

Of course, selling has its costs; nothing gets the teeth gnashing quicker than seeing a stock you sold double in price. Still, selling improves the odds of missing the sudden collapse of an AIG or a Bear Stearns and minimizing the damage of a slow, seemingly permanent descent of a Kodak. Both trips are often impossible to portend.

Selling also shields investors from those decades-long round trips. Of the handful of DJIA stocks that have been components for 50 years or more, three -- General Electric (NYSE: GE), DuPont (NYSE: DD), and Alcoa (NYSE: AA) -- are trading at 1995 levels.

In other words, if you are a long-term investor, it's worth vetting your portfolio from time to time. Consider selling issues that are becoming a little long in the tooth. The longer the times are good, the greater the odds they will turn bad.

 

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