The High Cost of Friction

As investors, we worry too much. This is especially true when market downturns take bites out of our paper wealth. At such times, the urge to do something -- anything -- to stanch the bleeding can lead us to take foolish (lowercase "f") action at inopportune times. But for the long-term-focused investor, heeding the urge will most likely do more harm than good. Emotional investing can lead to commissions, taxes, and bad decisions.

Timing the market
In a Fortune article, written at the height of "bubble-dom" (November 1999), Warren Buffett estimated that the annual costs borne by investors moving in and out of the Fortune 500 alone was on the order of $100 billion. A massive number, to be sure -- but it becomes more staggering with some context. That $100 billion represented 30% of the total profits of the Fortune 500. Forgetting valuation for a second, if investors (in aggregate) cannot get anything out of the business except what the business earns, then frittering away 30% annually by playing Wall Street musical chairs would seem downright foolish.

Stop your losses
Surely, some trading makes sense, right? A lot of investment strategies advocate setting stop-loss orders to protect your downside. Sounds reasonable, but costs can add up quickly. Take a look at the performance of Motley Fool Hidden Gems pick Middleby (Nasdaq: MIDD  ) from its original recommendation in October 2003:

Strategy Value of original $1,000 investment
Buy and hold $3,798
10% stop-loss order $2,937

By practicing a strict discipline of selling when the stock falls 10% and then buying back 5% above the bottom of each trough, the investor using stop-loss orders has bought and sold the stock nine times in two years and has knocked about a quarter off his total return. Did I mention this underperformance is before accounting for commission costs and capital gains taxes? Plus, he's likely given himself an ulcer watching the stock and tweaking his stop-loss orders.

Protection money
So what's an investor to do? If nimbly stepping in and out of our favorite companies isn't the answer, perhaps we should look at a form of insurance for our paper profits.

One strategy is a "protective put," which involves buying a "put" option on a stock. If a downturn comes, you can sell out at a predetermined price. Let's look at puts on three much-discussed Hidden Gems recommendations. Each of these puts has the longest "time to expiry" possible (March 2006), which gives five months of downside protection. Also, each option is slightly out of the money, giving us a balance between protection and low(er) cost.

Deckers Outdoor (Nasdaq: DECK  ) Select Comfort (Nasdaq: SCSS  ) Mine Safety Appliances (NYSE: MSA  )
Stock price on Oct. 13, 2005 $20.16 $17.76 $36.97
Put option strike price $20.00 $17.50 $35.00
Cost of put option $2.65 $1.85 $2.85
Cost of protection 13.3% 10.6% 8.1%
Cost of protection (annual) 31.8% 25.4% 19.5%

Ouch. The Deckers put option, for instance, gives five months of protection at a cost of more than 13% of our expected selling price (if we exercise). If Deckers is above $20 in five months, and presuming we'll still be of the protective mindset, we might buy another put. Assuming costs of protection remain unchanged, our 13% turns into nearly 32% on an annual basis. Put another way, that 32% is what Deckers would have to appreciate in the upcoming year to justify the cost of protection. It's telling that the other industry peddling "protection" at these rates is featured on The Sopranos.

Tally all costs
Sometimes, there might be good reason to sell a stock and contribute your part to Buffett's frictional cost estimate. However, before acting, carefully consider all of the costs of both selling the stock and purchasing the new stock. Included here are the explicit costs of sales commissions on both ends of the transaction, as well as the capital gains taxes you may or may not have to pay (if the stock is in a tax-sheltered account). Then there are the implicit costs. By selling, you give up the future gains of the former stock -- an opportunity cost.

Any new investment must be purchased at a sufficient discount to offset all of these costs. Otherwise, why bother changing horses? While commissions and taxes are relatively easy to calculate, that implicit opportunity cost can be a problem. I've put together a spreadsheet here, which should hopefully help smooth the process, but it does require some judgment as to how the business will grow and what future multiples are appropriate. Admittedly, there is art heavily commingled with science.

For fun (and illustration) I looked at some scenarios for Google (Nasdaq: GOOG  ) , assuming that I bought the company at $100 (I didn't) and was looking to sell it at $350 (I'm not). All scenarios assume a capital gains tax rate of 20%, commission costs of $10, and five years explicitly forecast:

Annual sales growth 40% 30% 25%
Annual earnings growth 40% 30% 25%
Annual share dilution 3% 3% 3%
Expected price-to-earnings ratio 30 times 40 times 30 times
Expected price-to-sales ratio 6 times 9 times 6 times
Expected annual returns foregone 6.6% 6.2% -4.9%
Required return on new investment 11.1% 10.5% -0.8%

Our first two scenarios would require us to replace Google with another investment yielding more than 13%. However, it doesn't take much to skunk up the works. Assuming only 25% average annual sales and earnings growth and a 30-times multiple on earnings would require us to select a replacement with an expected return of just more than 3%. Which scenario is most likely? Again, that's where the art comes in.

The Foolish bottom line
Look, I know there are going to be short-term traders, technicians, and people confident that they'll never be the "biggest fool" that will disagree with me. That's fine. I'm just saying that, for the rest of us, we should learn to resist temptation. To again paraphrase Buffett, sometimes the best thing to do is nothing.

Fool co-founder Tom Gardner and hisMotley Fool Hidden Gemsteam scour the public markets for two small-cap market beaters every month. Since inception, Hidden Gems recommendations are up 23%, compared with a 5% gain for the S&P 500. For full access to the more than 50 small caps Tom and his team have picked,click here for a 30-day free trial. There is no obligation to subscribe.

Jim Gillies does not own shares of any company mentioned. The Motley Fool is investors writing for investors.

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