How Do You Choose an Investment to Hold for Five Years?
The stock market goes up and down and the business news reports every daily gain and loss as though it were a prediction for permanent success, or long term dismal failure. Pundits have likened the reporting of the stock market to an old-fashioned melodrama. Nellie is tied to the railway tracks. Will the hero get there on time? But, he is delayed. But, maybe she will get loose. Maybe the train will stop. However, agonizing over the daily fluctuations of the market is not really the best way to pick a longer term investment. Many successful investors only invest for the long term. This is typically at least five or ten years. With this in mind, how do you choose an investment to hold for five years?
Buy and Hold Investing
Investopedia defines buy and hold investing.
Buy and hold is a passive investment strategy for which an investor buys stocks and holds them for a long period regardless of fluctuations in the market. An investor who uses a buy-and-hold strategy actively selects stocks but has no concern for short-term price movements and technical indicators.
This approach need not be limited to stocks but can be used in real estate investing, the purchase of US treasuries or bonds, or in the running of your own business. This approach ignores short term static and focuses on longer term prospects. Investopedia says this in regard to the longer versus the shorter term focus.
Conventional investing wisdom shows that with a long time horizon, equities render a higher return than other asset classes such as bonds. There is, however, debate over whether a buy-and-hold strategy is superior to an active investing strategy. Both sides have valid arguments, but a buy-and-hold strategy has tax benefits because the investor can defer capital gains taxes on a long-term investments.
Long term investing reduces the “overhead” of investing as one is not continually buying, selling, and incurring fees and commissions. As, Investopedia notes, the investor is also not paying capital gains taxes every time he cashes out of a successful short term investment.
The fact of the matter is that most, if not all investors, are not all that successful all of the time at market timing. Thus, an investor may make lots of money by picking the right stock at the right time and then lose all of it when picking badly and not getting out in time.
How Do You Choose an Investment to Hold for Five Years?
Since the rule of thumb for long term investing is five years or even ten, how do you choose and ignore the static of “Nellie on the railroad tracks?” For the answer we need to go back to the days following the 1929 market crash and the Great Depression that followed. According to Investopedia, an American investor, Benjamin Graham, described a method for determining the long term value of a stock, comparing it to the current market value, and buying, selling, or holding the stock based on its intrinsic stock value. He first published a paper entitled Security Analysis and then a book entitled The Intelligent Investor. Investopedia says this.
Security Analysis was first published in 1934 at the start of the Great Depression, while Graham was a lecturer at Columbia Business School. The book laid out the fundamental groundwork of value investing, which involves buying undervalued stocks with the potential to grow over time. At a time where the stock market was known to be a speculative vehicle, the notion of intrinsic value and margin of safety, which were first introduced in Security Analysis, paved the way for a fundamental analysis of stocks void of speculation.
With his system, Graham looked at the P/E ratio of a “zero-growth” stock, the previous twelve months earnings per share of the company being analyzed, and the projected long term growth of the company. In a 1974 revision he included the yield of a high-grade corporate bond and the yield of a risk-free investment in bonds such as an AAA corporate bond like we mentioned in our article about how to invest without losing money.
Long Term Growth
A key part of this approach is the estimation of long term growth. In this regard an investor needs to have a clear idea about how the company makes its money and how its business will continue to make money over many years. Smart long term investors avoid companies and whole sectors where they cannot be sure how well the company’s business plan will work in five, ten, or more years. There are many examples of stocks in the tech sector that looked great for a couple of years until someone else developed a better technology and drove their profits down. Thus, many stocks that you would choose for investment for five years or longer are those with basic products and services, a strong consumer base, and a margin of safety. The margin of safety can be money in the bank, property such as factories that are unencumbered by debt, or a brand name (like Coca Cola) that is known throughout the world.
Investments That Prosper in Good Times and Bad
Years ago we wrote an article about Investing in Beer. Since that time there have been mergers that have changed the available stocks to buy but the basic rationale is still OK. Basically, people celebrate during the good times by drinking beer and people drown their sorrows in the bad times by drinking beer! Beer, like dish soap, shampoo, tooth paste, soft drinks, and other consumer items is consumed no matter how the economy, the stock market, investments in gold, real estate, or commodities are doing.
Utilities are a common choice for long term investment. These companies have reliable customer bases and their stocks are often considered proxies for bonds because of their high and reliable dividends.
So, when the stock market starts to correct, investors will pile out of their “growth” stocks and buy consumer stocks like Procter and Gamble, Coca Cola, and Anheuser Busch InBev or a utility stock like Southern Company.
Should All of Your Investments Be Long Term?
One of the best investments in modern times was when people bought Microsoft the day it went public. Its offering price at the March 13, 1986 IPO was $21.Today, adjusted for stock splits the stock is hundreds of times more valuable and the adjusted quarterly dividend is a healthy multiple of the original stock price. If you only chose “safe” long term investments with very predictable growth, you would have missed buying Microsoft at the IPO. The answer to this dilemma is diversification. Successful long term investors put the majority of their assets in investments chosen for the long haul using the intrinsic value approach. But, they apportion part of their portfolio, perhaps ten or twenty percent for stocks with growth potential with the hope that these stocks will mature and become long term reliable money-makers.