Seeing beyond a huge false dichotomy

This little exchange (see video above) between Professor Jeremy Siegel of Princeton's Wharton School and Barry Ritholtz of Fusion IQ brings out an important misconception that plagues many investors and which, unfortunately, was not directly addressed by any of the participants in the conversation during the discussion.

In the video, host Larry Kudlow asks whether a young person today, having observed the stock market carnage of the last decade, should invest in stocks "for the long run," using the phrase made famous by guest Jeremy Siegel in his Stocks for the Long Run, first published in 1994.

Guest Barry Ritholtz says, "They should buy stocks, but the caveat is they shouldn't just buy them and put them away; they should buy them and engage in risk management; they should use stop-losses --"

"You wanna trade them!" interjects host Larry Kudlow.

"No, no, I don't mean aggressively trading -- I mean you use a trailing stop-loss. You can own any stock in the world, including Enron, and as long as you have a stop-loss fifteen percent below that . . ."

The conversation continues along those lines pretty much for the rest of the segment, with Professor Siegel arguing that attempts to market time lead to increased transaction costs and taxable events, as well as the difficult problem of determining when to come back in if you get stopped out of all your holdings, and Mr. Ritholtz making the point that if you owned companies that were heading towards bankruptcy, you don't need to worry about taxable events, because all you will have are total losses.

Unfortunately, nobody in the segment took a step back and pointed out that the conversation is a huge false dichotomy, and since this is an important point for investors (as well as an argument that plays itself out over and over in cocktail parties, bars, and backyard barbecues across the land), we will try to step back and point it out here in the Taylor Frigon Advisor.

We advise investors to follow a course that neither holds companies forever nor trades them based on market-driven signals. A stop-loss order (in which the investor places a trade order to sell shares of a holding after the price hits a certain trigger below its current price) is a market-driven signal, dependent upon the moves of the market, rather than a business-driven decision based on the underlying business prospects of that company.

This is the distinction that all of the participants of the above discussion overlooked. Instead, we advise investors to follow a different path:

• We advise owning good businesses through multiple economic cycles. Jeremy Siegel and Larry Kudlow were on the right track when they noted that jumping in and out of a company whenever its stock suffers a market-based reversal is a losing proposition in the long run, as we explain in previous posts such as "Ownership of businesses through multiple economic cycles."

• However, it is important to realize that companies themselves have life cycles. As we explained in an important post entitled "Remaining calm without being blind and obstinate" the very term "growth investing" came from the observation in the 1930s by the late Thomas Rowe Price that "corporations have life cycles similar to those of human beings." Investors should seek to own companies during the growth phases of those life cycles, and sell their ownership in those companies when it becomes clear that they are no longer in the growth phase of their business life cycle.

• Market-driven triggers such as the ones that Mr. Ritholtz was discussing in the above video are not the only alternative to buying and holding forever, although from most discussions you hear on this subject you might get that impression. We explain in some detail the sell discipline that we follow and that we recommend investors follow in "The importance of a proper sell discipline."

• Mr. Ritholtz named several companies in his argument that had notorious drops in share price on the way to disappearing altogether. The best way to avoid such drops is not to buy those companies in the first place. We explain the criteria we look for in a classic Taylor Frigon growth company in several previous posts, including "Beautiful Growth Companies," "Beautiful Growth Companies, part II," and "Beautiful Growth Companies, part III."

Finally, we believe that investors should always think of investing as an act of matching capital with innovation. This is the important thought that was not brought out in the exchange of ideas captured in the film above.

It enables those who understand it to see beyond the folly of trying to trade back and forth based on market movements (or based on complex computer algorithms that watch market movements -- as we have explained here and here, no algorithm can predict where the next unexpected innovation will arise, because innovation by definition is unexpected).

It also enables those who understand it to see beyond the "buy and hold" mentality, because they will realize that companies do not typically continue to bring about what Clayton Christensen calls "disruptive innovation" to their industry forever.

We hope that this discussion helps investors to see beyond the widespread confusion on this important subject.

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For later posts dealing with the same subject, see also:

• "Panning for gold during unfriendly business climates" 09/30/2009.

• "Would you sell your successful local restaurant because of a debt hiccup in Dubai?" 11/30/2009.

• "Some lessons from 2009" 12/28/2009.

• "Market-timing and train-timing" 05/25/2010.

• "Another wake-up call" 11/29/2010.