by Alexander Green, Investment U’s Chief Investment Strategist
Monday, December 6, 2010: Issue #1401
Patrick Henry famously declared that he knew no way of judging the future but by the past.
So if you’re putting together a long-term investment portfolio, it might be wise to look at the historical returns for various types of assets. Not just for the past few years, or for several decades, but for the past couple centuries.
When you do this, you’ll notice something interesting:
It therefore follows that an investor seeking maximum capital appreciation might focus on identifying undervalued small-cap stocks.
But there’s only one problem with this: It won’t work for most investors, even if the future is very much like the past. Here’s why…
Beware the Value Investing Trap
Value stocks require something that growth stocks don’t: Patience.
When a stock – either large or small – is in the cellar, it’s there for a reason. Typical ones are that the company is:
As a value investor, you don’t know when these state of affairs will end, but you might be tempted to invest in a company if it’s relatively cheap in relation to sales, earnings or book value (i.e. net worth) in the hope that management will set things right.
The problem is this can take quite a long time. Or it may never happen at all. As the stock gets cheaper and cheaper, you may believe it’s becoming an even better bargain. This is the classic “value trap.” And if you keep buying a stock on the way down, it may very well have your name on it when it hits rock bottom.
Dead Money With Decent Dividends
Even if a value stock is destined to generate a good return over, say, a three- to five-year horizon, most investors won’t be around to enjoy it.
How do I know this? Because as a former money manager, I’ve dealt with thousands of “typical investors.” And regardless of what they say in their initial interview about their willingness to stay the course and think long-term, it all goes out the window for 90% of them when the road gets bumpy. Or if things don’t kick into gear right away.
A client who sits on a stock – or even a stock fund – for six months and doesn’t see a spark will remind you with every conversation that he or she is sitting on “dead money.”
No argument there – they are (at least temporarily). But value stocks often pay decent dividends that help compensate for this. Early in my career, however, I got tired of holding hands and counseling patience and switched from a value to a growth methodology.
It was a good move. If you want action, you should have it…
There’s No Shortage of Excitement with Growth Stocks
Buy the best growth stocks you can find. Given that they tend to be twice as volatile as the market (and twice as expensive), there is generally no shortage of day-to-day excitement.
But if you use a trailing stop, you can generate results that are much better than historical long-term returns (which always assume a buy-and-hold approach) and with less risk because your positions are fully protected.
So unless you have the patience of Job – and most investors don’t – you’re better off owning growth stocks than value stocks and, of course, using a trailing stop.
In my next column, I’ll demonstrate why small-cap growth – historically the worst-performing long-term equity class – is the very best place to find blockbuster stocks.