Why Warren Buffett Is Wrong About Trading In and Out

NFLX2

Continuation from yesterday…….(What Will Happen To Netflix When A Bear Market Starts)

Justifiably, some will argue that constant trading in and out of your position can increase capital gains taxes and therefore reduce returns. Let’s take a quick look at the numbers based on the Netflix’s trading pattern above to settle the matter once and for all. First, we have to make the following assumptions.

You fall into the 25-35% tax bracket and your long-term capital gains tax is 15%.
Your average ordinary income tax is 30%.
We liquidated our position as of today at $460. Giving us a net realized total return of 1,740% for “Buy and Hold” and 10,817% for “BLSH”.
Original investment of $100,000

If we run the scenario above our total after tax return on investment for the “Buy and Hold” investment strategy will yield a return of $1,479,000 or 1,479%.

For the “Buy Low, Sell High, Go Short & Cover” investment strategy and based on the trades above, an after tax return on investment will be equal to $6,977,321 or 6,877%. If you are counting, that is still more than 4.5 times higher than a simple buy and hold approach used by most investors out there.

Finally, there is yet another hidden benefit to our newly discovered investment strategy. Investors who follow the “Buy Low, Sell High, Go Short & Cover” strategy should be able to avoid company or industry specific risks associated with investing in certain companies.

One of the most common mistakes all investors commit when making long-term investment decisions is relying too heavily on the fundamental analysis. And while fundamental analysis is great, it is fairly useless when it comes to identifying proper entry and exit points. In fact, in 99% of the time the underlying stock price will either surge or collapse by the time important fundamental factors flow though the company’s financial statements or press releases.

Remember, the stock market is a future discounting mechanism. That means the stock price is likely to reflect all changes before they become evident on the fundamental level. For instance, earlier in the book we have looked at the Nasdaq’s trading pattern over the last 20 years. And we don’t have to go further than 2007 top and 2009 bottom to illustrate this principal in action. At 2007 top most market participants were incredibly bullish. The US economy was doing great, fundamentals looked good and the FED Chairman Bernanke was concerned about the economy overheating as late as second quarter of 2008.

Yet, the stock market topped out on October 11th, 2007 and accelerated down. By the time fundamentals caught up to the stock market in 3rd and 4th quarter of 2008, about 75% of the entire decline was complete. The situation was entirely reversed at 2009 bottom. If you recall, most media and financial outlets were calling for the next “Great Depression” and the sky couldn’t be darker. Luckily, the stock market bottomed on March 6th, 2009 before staging a massive 5.5 year rally. And again, it took the fundamentals about two years to catch up with all of the positive developments.

Point being, once again, by the time underlying fundamentals filter though, it is oftentimes too late to either get in or get out. The same line of thinking applies to all individual stocks. When we apply “Buy Low, Sell High, Go Short & Cover” investment strategy we gain the ability to avoid the risk of being caught on the wrong side of the trade. It allows us to eliminate the risk of waiting to see what happens from the fundamental perspective. It allows us to avoid losses most often associated with unforeseen consequences associated with investing. Most importantly, it puts us in the position of power.

For instance, Netflix’s 2011-2012 collapse gives us a perfect illustration of the subject matter. Outside of its general overvaluation there were no fundamental reasons for Netflix to go through a 75% correction during that time. Certainly not in 4 months. Yet, the stock price topped out in July of 2011 and quickly collapsed. Followers of “Buy Low, Sell High, Go Short & Cover” wouldn’t care why the stock price was collapsing. They would have exited the stock and gone short as soon as the technical confirmation was obtained.

Subsequently, investors would find themselves at the bottom of the trading range were all of Netflix’s “Fundamental Bad News” would have come out. And while it would be too late for traditional investors who would be sitting on top of massive losses, followers of BLSH would find themselves in a position of power. Trying to decide whether the fundamental news are indeed bad or if the fears are being overblown and the stock price is likely to bounce. Allowing them to re-enter the position right at the bottom or as soon as the stock begins to break out.

In other words, Buy Low, Sell High, Go Short and Cover allows investors to minimize risks most commonly associated with relying too heavily on fundamental analysis.

To Be Continued Tomorrow……..