Volatility

One of my favorite Ben Graham quotes is from the introduction to the 1949 version of The Intelligent Investor:

"In nine companies out of ten the factor of fluctuation has been a more dominant and important consideration in the matter of investment than has the factor of long-term growth or decline. Yet the market tends to greet each upsurge as if it were the beginning of an endless growth and each decline in earnings as if it presaged ultimate extinction."

The Intelligent Investor, by Benjamin Graham (HarperCollins Publishers, 1949). As this quote suggests, you don't ignore stock price volatility -- you take advantage of it.

With all due respect to Phil Fisher, Warren Buffett, and Charlie Munger, the fundamental problem with buy and hold forever investment strategies is that you're not taking advantage of volatility and Mr. Market's irrationalities. In making this choice, the buy and hold forever investor forgoes a consistent, time-tested driver of stock market returns: temporary stock mispricings due to irrational volatility. The buy and hold forever investor places sole or primary reliance on a far less certain driver of long term returns: future earnings growth and future high returns on capital.

As discussed by Tobias Carlisle in Deep Value and The Acquirer's Multiple, competition and mean reversion make reliance on future growth and future returns on capital a very uncertain bet. High margin, high growth companies usually mean revert due to: (1) new entrants and future competition; (2) new, disruptive business models; and/or (3) new technologies that make a company's product obsolete.

With buy and hold strategies the general thought is that it's okay to hold onto positions that are temporarily overvalued -- a la Phil Fisher -- because even if the stock price retreats a little you still do well over the long term. To me this doesn't make sense. Why give up the incremental annual return that irrational volatility can provide, particularly when even small increases in annual returns can have a big impact on compounding and long term returns? Why not reduce your opportunity costs by taking advantage of volatility, buying or holding onto positions when they're undervalued and selling them when they're overvalued?

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.