Sunday, June 27, 2010

Is Breaking Even Equal to Breaking Up?

In my continuing search to locate the missing buyers that are needed to put the stock market on a higher plane, I have learned from others the expressed view that it is too painful to buy more when one has not broken even. Emotionally I understand this. One does not want to go through a breakup, either of a personal relationship or a firm, but often that is required before moving on to the next phase or new relationships. One of the reasons to avoid breaking up is the desire not to unduly hurt other parties. Often this means staying in an unhappy relationship too long for all involved. In a somewhat analogous way, holding on to securities or perhaps investable cash can hurt. But in these cases the hurt is to the investor and possibly the beneficiaries.


Whether an investment is to be successful is a function of future prices, either in absolute or relative terms. Unlike human relationships which are based somewhat on the conditions of the participants when they enter a relationship, stock prices don’t remember your entry prices. Only the tax collector primarily cares whether your transactions produce a net profit or a loss and over what length of time between purchase and sale dates. One of the many errors people make is that they carry their investments at current prices. Since we have been told that the only certainties in life are death and taxes, we should carry our assets net of expected income and/or estate taxes. One of the curious things that happens when a purported price rises above our purchase price is that we might consider it goes from a usable tax loss to an incipient tax liability. Neither condition should heavily influence investor actions. In this case, unlike human behavior/memory, the future will not be determined by our past.


Freeing up investment capital for better investment is the essence of sound investment activity. While we are struggling today with the unknowns of future stock prices, we can easily believe that some prices will grow faster than others. In a vast oversimplification, future relative stock prices will be a function of how rapidly corporations will grow their businesses and what relative change the market places on its collective valuation. This philosophy leads one in the direction of selecting improving companies with more modest valuations, a difficult combination to find. (We hope, on balance, the portfolio managers we have selected for clients do a reasonably good job of selections for the various futures.)

At the current levels in the stock market, one would think that many stock prices do not represent a positive future valuation even if they do improve as one might expect. These stock prices compare with some of those that we own that are good companies with not much chance for above-average improvement. Therefore, some switching appears in order for a number of positions.

By the way, if one is to be truly analytical, positions should be viewed in terms of the real dollar level at the time of purchase. Thus many of the gains that we hold are not up as much as we believe. If you believe as I do, that on a long term basis the purchasing power of the dollar will decline, to maintain your standard of living you need to find investments that will grow faster than the dollar’s purchasing power decline.


In the past, mutual fund investors often redeemed their shares when they had broken even. In most cases they defined breaking even as when the net asset value currently quoted to them was higher than their remembered purchase price. Again, from an analytical viewpoint this calculation is misleading. Over time they have received income and hopefully capital gains distributions, plus in some cases return of capital distributions. These should be added back to the initial price if one wants to compare the performance of the fund versus some stock prices. Another add-back should be the sales costs, management costs and administrative expenses paid. That some of these costs did not produce the intended results is immaterial in that they were paid by the fund investor. Thus, often fund investors have done relatively better than they thought.

Bottom line: do not let the fear of the tax collector put your holdings in a “quasi-tax jail.” Be among the early-renewed buyers of potential future winners. When the other buyers catch-up to you, they will probably be paying higher prices.
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