Investing guru Jim Cramer, author of Jim Cramer’s Real Money, espouses the foolishness behind conventional wisdom to “buy and hold,” “own don’t trade,” and “never speculate.”
I, like everyone else who has ever bought a stock, believed in conventional wisdom about stocks. In fact, I can sum up the doctrine I foolishly believed in with three rules:
- Buy and hold because that’s how you make the most money.
- Trading is always wrong, owning is always right.
- Speculation is the height of evil.
I guess it is only fitting in a book written by a successful investing iconoclast that the first thing we do is demolish these three shibboleths. They are blights on the investing landscape, idols that must be smashed before we go a step further. So, let’s do it.
First, the concept of buy and hold is a beautiful thing because it presumes a level of ease and a level of perfection that we should all strive for. What could be better than a philosophy bed rocked in patience and conviction? Unfortunately that level of conviction about pieces of paper — all that stocks really are, and don’t you ever forget it — is impossible. Patience, while a virtue, can turn into a vice when you sit there and watch a good company go bad and hold on to its stock anyway under the guise of prudence. I can say with confidence that an unmodified program of buying and holding stocks will definitely smash your nest egg worse than a McDonald’s cook whipping up a fresh batch of Egg McMuffins. Buying and holding is actually a bizarre misinterpretation of the long-term data that I have quoted about why you need to stay in the game. Given that no asset class has beaten equities over any twenty-year cycle, it is natural to assume that if you buy stocks and hold them you get to beat all other asset classes. However, the foremost academic on this particular issue, Jeremy Siegel, a Wharton professor, blanches visibly when he hears the distillation of his work interpreted as a recommendation to buy and hold stocks. Siegel’s work shows that if you buy and hold good quality stocks that often pay dividends, you get the benefit of the cycle. In fact, the dividend portion is the reason why stocks outperform bonds, and not vice versa. Take it away, and you fail to win. Just buying and holding any old stocks, Siegel will tell you, can be a ticket to the poorhouse.
That’s why on Jim Cramer’s Real Money, I have changed the superficial buy-and-hold mantra to the more arduous “buy and homework” doctrine, meaning that the real homework begins after you have bought a stock. Just buying and holding Sunbeam, Enron, WorldCom, Dome Petroleum, and Lucent, each at one time the most heavily traded stock of its era, was a recipe for certain disaster. Homework, or the spadework that I describe to you in my chapter on what constitutes homework, would have gotten you out of all of these stocks before the damage and the rot set in. Again, not buy and hold, but buy and homework. If you are going to make big money in the market, only with homework can you be sure that your stocks qualify as good quality stocks that can pay a dividend.
Second, the idea that trading is somehow evil is ingrained in most individuals almost from the moment they begin to invest. Stubborn adherence to this point of view has led to more big losses than any other strategy I know. Trading, meaning the rapid or short-term buying and selling of stocks, is something that can prove to be entirely necessary if you are to be prudent and lock in gains when the market takes stocks past their logical extremes, which happens quite frequently in every generation of stocks. If you chose to never sell because, say, you are afraid of the tax man, or because you despise paying commissions, you need to get your head examined. When I got into this business, it made some sense not to sell. It would routinely cost you several hundred dollars in commission to trade more than a couple of hundred shares. When combined with the spread, the difference between the bid and asked, for all but the most liquid or heavily traded stocks, a diminution of return was almost a given. A quarter of a point of spread, $200 in commissions, and gigantic taxable gains might have turned a substantial gain into a moderate loss on a trade. But that was then, this is now; we are in a whole different ballgame. Taxes these days are incredibly low even on short-term gains, because ordinary tax rates are much lower than they used to be. Trades that would have cost hundreds of dollars in commissions will now be done for about seven dollars by any discount broker. The liquidity of almost all stocks is pretty terrific since the advent of decimalization, where stocks trade in penny increments. You no longer get nicked for quarters and halves on the buy and sell. Pennies, just pennies separate almost all of the places you can buy and sell stocks. They just don’t eat into the profit anymore. You can’t use them as an excuse not to take a profit. In fact you have to be a fool not to sell to lock in at least some of a big gain these days lest it be taken away. The old bias against trading, however, remains as people simply don’t know how little friction there is between the buy and sell these days.
Finally, the bias against speculation has taken on mythic proportions. I don’t know of a soul besides me who thinks that speculating can be a handy tool on the road to riches. Yet I know that all of my biggest gains, my largest wins, came from pure speculation, which I define as making a calculated bet with a limited amount of capital that turns into a monster home run. I believe that speculation is not only healthy and terrific, but is vital to true diversification. You must be diversified to stay in the game when things go bad. (More, later, about how diversification is the only free lunch in the business.) But diversification without speculation is stultifying and can mean the difference between your losing interest — which is unforgivable — and your paying attention. Speculating, particularly when you are younger, is not only prudent, it is essential to making it so you don’t have to be totally dependent on that darned paycheck to become rich. I believe in my heart and in my head that if I had never speculated I would be working as a lawyer right now, perhaps proofreading some indenture somewhere in the middle of the night trying desperately to stay awake as others made the money. You’ve got to build in speculation as part of diversification. It is a crucial component.
I play a game called “Am I Diversified?” every week on my radio program. I ask people to read to me their five largest holdings. When they have done it they have to ask me whether they are diversified. I feel so strongly about this notion that I have taken to asking why people don’t have one stock bet that could make them significant amounts in a short time. I want to see speculation for a portion of even an older individual’s portfolio, albeit only a name or two — a small percentage — to keep you interested. Given the nature of the potential losses I don’t want someone who will need the money for retirement to speculate with more than a fifth of his portfolio. You have to make taking a chance a part of your arsenal.
ABOUT THE AUTHOR
James J. Cramer, author Jim Cramer’s Real Money (Copyright © 2005 by J. J. Cramer & Co.), is the cofounder of TheStreet.com, host of CNBC’s Mad Money, and “Bottom Line” columnist for New York magazine.
MORE ARTICLES BY THE AUTHOR
- The Basics of Building a Portfolio
- How Stocks Are Meant to Be Traded
- The Importance of Stock Price in Building a Diversified Portfolio
- Spotting Bottoms in the Stock Market
LEARN MORE
- Read Chapter 1 of Jim Cramer’s Real Money: Sane Investing in an Insane World
- See the book’s Table of Contents
- Browse more books by James J. Cramer
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