Most of us believe that experience in an occupation, measured by time spent on the job, leads to higher productivity for the employer and greater income for the employee. I agree that this belief holds true for most occupations. However, I disagree when it comes to the business of providing investment advice. In this business, the best experience is gained when an advisor’s own wealth is at risk, and his or her decisions are measured by personal dollars gained or lost. While it’s always good to be right about your investments and make money, the most valuable knowledge is gained through the experience of being wrong.

I am sure many practitioners will take offense at this idea, and there are numerous academic studies that will provide “proof” for their own investment approach. They may run Monte Carlo simulations and state probabilities of outcomes with utmost confidence, advising you to manage your savings accordingly. They may tell you about their collegiate degree, their hard earned professional designation, or their years of experience providing advice. All of these are positive things, but they are only part of what is needed in improving investment results. The remaining requirement is the emotional experience that comes only when one’s own money is on the line.  

Market prices for common stocks and bonds are at historically high levels in today’s market. This fact by itself is not important, at least to us. What is more important is that market prices relative to investment value are also at very high levels. All publically traded securities have an investment value and a speculative value. It is our job to attempt to separate these two elements, for both the price of each individual security and for the market in totality.  Determining an investment value is easy. It is the speculative value that is near impossible to measure. Most of our attempts to do so have taught us a good lesson, and have thus influenced our approach to portfolio management.

A diversified portfolio of common stocks has a rich history of performance, both in preserving wealth and increasing it over a lifetime. This fact, plus our belief that it is impractical and impossible to determine future highs and lows of market prices, has led us to conclude that a portfolio for individual investors should always include some common stocks. Of course, the weighting of common stocks in a portfolio is subject to each individual’s needs as well as their emotional ability to withstand large fluctuations in prices. In a non-restricted investment portfolio, the percentage of common stocks held should be adjusted downward when the degree of speculative value exceeds an estimate of investment value inherent in the current market price. This percentage should continue to decrease as the speculative value increases. I mentioned earlier that we learn the most from our mistakes, and I learned an important lesson many years ago: it is easier to buy and sell than to just sit tight.

Sit Tight

The title of this letter references a story from Edwin Lefevre’s book, Reminiscences of a Stock Operator, originally published in 1923. Larry Livingstone, the book’s protagonist, was a pseudonym for Jesse Livermore. The particular story from the book that I am sharing with you involves the lessons Larry learns from Elmer Harwood and Mr. Partridge, also known as Turkey.

In the story, Harwood, a broker, had given Mr. Partridge a tip to buy Climax Motors. Old Turkey had purchased 500 shares of Climax. Mr. Harwood, after a seven point rise in the market price, told Turkey to sell his shares. The rest of the story follows:

            “My dear boy,” said old Partridge, in great distress—“my dear boy, if I sold that stock now I’d lose my position; and then where would I be?”

            Elmer Harwood threw up his hands, shook his head and walked over to me to get sympathy:  “Can you beat it?”  he asked me in a stage whisper. “I ask you!”

            I didn’t say anything.  So he went on:  “I give him a tip on Climax Motors.  He buys 500 shares.  He’s got seven points’ profit and I advise him to get out and buy ‘em back on the reaction that’s overdue even now.  And what does he say when I tell him?  He says that if he sells he’ll lose his job.  What do you know about that?”

            “I beg your pardon, Mr. Harwood; I didn’t say I’d lose my job,” cut in old Turkey.  “I said I’d lose my position.  And when you are as old as I am and you’ve been through as many booms and panics as I have, you’ll know that to lose your position is something nobody can afford; not even John D. Rockefeller.  I hope the stock reacts and that you will be able to repurchase your line at a substantial concession, sir.  But I myself can only trade in accordance with the experience of many years.  I paid a high price for it and I don’t feel like throwing away a second tuition fee.  But I am as much obliged to you as if I had the money in the bank.  It’s a bull market, you know.”  And he strutted away, leaving Elmer dazed.

A few paragraphs later Larry Livingstone shares the lessons learned from old Turkey. 

            And right here let me say one thing:  After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this:  It never was my thinking that made the big money for me.  It always was my sitting.  Got that?  My sitting tight! ….That is why so many men in Wall Street, who are not at all in the sucker class, not even in the third grade, nevertheless lose money.  The market does not beat them.  They beat themselves, because though they have brains they cannot sit tight.  Old Turkey was dead right in doing and saying what he did.  He had not only the courage of his convictions but the intelligent patience to sit tight.

Valuation and Expected Future Returns

We know that the stock market has been rising these past eight years, ever since its low in March of 2009. Because this is one of the longest market advances in history, we automatically worry that the end is near. It very well could be, but the market could also continue its advance for years to come. A few times in the past I have had to “sit tight” with a percentage of common stocks in our portfolios that pushes against my sleeping point, keeping me up at night. If prices continue to move higher without some rapid increase in investment value, my sleep will suffer further, and once again we will sell a little more. 

Currently, our research is telling us that from this price level, the return of the S&P 500 (SPY), including dividends, will be a little less than 6% annually for the next five years. This is our estimate of investment value as calculated today, not future market value. That value will be set by others, both speculators and investors. As you know, 6% total return is well below historical levels, including those of the last ten years, which produced a 7.25% return. A 6% return is enough to preserve wealth, but with a limited margin for error once we account for cost, taxes, and inflation. On the other hand, interest rates paid on US Treasury obligations and FDIC insured certificates today offer little hope in preserving wealth. Given that, we must “sit tight” and wait for the change that will surely come, reallocating portfolios when opportunities arise.