The Trader's Dilemma

Whenever the markets slip a bit, we hear that buy-and-hold investing "never works."

The short-term traders make two main arguments against fundamental analysis: 1) You can't rely on company-provided information, and 2) markets are just an amalgamation of buyers and sellers at a given moment in time, so all you can do is chase the nervous herd every day to make a profit. I think they're wrong on both counts.

Knocking down the straw man
The rise and fall of the dot-coms, plus the spectacular accounting frauds at Enron, Tyco (NYSE: TYC  ) , HealthSouth (NYSE: HLS  ) , WorldCom, etc., produced a new school of fundamental-analysis skeptics. Since a few companies were paper tigers or outright frauds, they argue, all companies run a risk of turning out the same.

A freshman-level Logic 101 professor would knock down that straw man in a hurry. It's called a spurious correlation: "If some, then all" is not a viable hypothesis.

If some people who get in an automobile are injured or killed, should I avoid all ground transportation? If an even smaller number who board an airplane are killed, should I avoid flying? If some prescription drugs have unknown side effects and adverse interactions, should I refuse to take all prescription drugs on principle?

Of course not. If I avoided cars, planes, and prescription drugs, my life would be pretty limited. Investing is the same way.

Who's the richest investor in America? Warren Buffett of the Berkshire Hathaway (NYSE: BRK-A  ) empire, of course. What philosophy does he follow? Value investing. How many superbillionaires made their fortunes in short-term trading? Not many. A few of the top hedge fund managers did, but not that many. Suffice it to say that they don't come close to Buffett on the 100 richest people in America list.

The problems with excessive trading
Trading sounds so easy in hindsight. One of the charting services has a commercial on CNBC that reminds me of a third-grade math class: "Look at this stock. It went up here, then it went down here. If you knew in advance where it was going, imagine the money you could make."

Duh. And if I were the Prince of Wales' elder son, I would be the King of England one day. But I'm not. Only a very small, very select group of people ever become a monarch, just like only a few can untangle the mystery of technical analysis well enough to make a good living at it.

Traders face many more hurdles than investors. Diversified investors have to pick 20-40 stocks for a good-sized portfolio, decide when to buy, follow the news, and then decide when to sell. They can buy and hold for years if they like; Buffett often says he wouldn't mind if the markets closed for a year or two.

A trader, on the other hand, often makes more than 1,000 "round-trip" trades every year. That's more than 2,000 buy-and-sell decisions in several hundred stocks. The odds of making bad decisions go up exponentially with the number of decisions you have to make.

Traders get smug when the market dips and they're sitting mostly in cash, but they go strangely silent in sustained runups where the 100% invested fundamentals guy makes his big returns for the year. A trader who goes to cash after every trade has to go out and find new trades each and every day to keep up with the investor. The fundamentals guy can wake up in the morning, decide his portfolio is fine, do nothing all day, and still beat the markets over time.

The list of stocks that doubled, tripled, quadrupled or better since the market lows in 2003 goes on and on. It's a classic tortoise-and-hare story. The hare is flashy and full of energy, but he's also easily distracted and likely to burn out before the finish line.

The fundamentals investor has to endure market setbacks and protracted periods of boring portfolio performance. Over time, however, the small number of well-informed decisions he makes should bring a superior return.

The argument that a stock is only worth what the herd will pay for it right now comes from the efficient-market hypothesis. It says you can never do better than what the market offers right now, because the multitude of players know so much that all possible information is already priced in to the stock.

Nonsense. If markets were efficient, I couldn't make a living. Even with rudimentary fundamental analysis knowledge, you can find undervalued stocks whose hidden sterling qualities have not been priced in yet. Otherwise, no stock or portfolio could ever beat the market indices. But every year, thousands of stocks do better, and at least several hundred fund managers do the same.

So can you.

See also:

Motley Fool Stock Advisor has been able to beat the market by 40 percentage points using a buy-and-hold strategy. Click here for more details.

Tyco is an Inside Value pick.

Fool contributor Dale Baker, a private client portfolio manager, owns Berkshire Hathaway B shares for himself and his clients. He likes making money by doing very little and welcomes your questions or comments. The Fool's disclosure policy has faith in you.


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