Good morning! Today Troy continues about the investing for beginners series. You can check the previous posts about What are stocks and how to value them, How does Currency Trading Work, How are Currencies Traded, Investing in Commodities, What Fundamentals Affect Commodity Prices, What are ETF’s, What are Options, How are Options’ Prices Structured, Investing for Beginners Part 2 – Different Investment Strategies, When does Buy and Hold not Work
In my previous post I discussed the reasons why the conventional buy and hold method doesn’t work. Why? Because the likes of Warren Buffett and other buy and hold supporters are keeping you in the dark on some critical things. Below are the additional “factors” you need to add in order to make buy and hold work for you. Without these factors, buy and hold will not work – you’ll be like the poort sap who dumped their stocks at the bottom of the 2008/2009 stock market crash.
You Need a Side Business
Warren Buffett’s company Berkshire Hathaway (really just a legal entity that owns other companies) is a very unique business. And no, it’s not because “Warren Buffett buys cheap stocks, value stocks, Buffett’s a great guy blah blah blah”. It’s because of Warren Buffett’s investment model. Buffett’s true buy and hold strategy works something like this.
Start off with $200,000 in 1950 (yes, Buffett’s dad was a Congressman in the 1940’s/50’s). Buy a company (let’s call it Company A). Use the cashflow from that Company A to buy shares in another attractive company (let’s call this Company B). Eventually have enough cash from Company A to buy all of Company B. Use the newly combined cashflow to buy shares in Company C. Eventually have enough cash from Company A and Company B to buy all of Company C. Repeat this process with Companies D, E, F, G, and so on.
Thus, Berkshire Hathaway is a Buy and Hold Machine. That’s why Buffett’s biography is called The Snowball. Your investments will snowball as you own more and more companies. The mechanisms of this investment strategy are real slick. The cash generated from businesses goes into investing in other businesses, which increases the cash flow, which allows for more businesses to be bought, which generates even larger cash flows. And the cycle repeats itself.
Obviously, you and I don’t have $200,000 to start off with ($200,000 in Buffett’s time is equivalent to $2 million today). Thus, we need to start our own business. Since most of y’all are working full time in other jobs, this will have to be a side business. Many financial bloggers are doing this – Pauline (based on her monthly income reports) makes somewhere in the neighborhood of $3000, and she’s doing this while touring Europe!
Once you have that side business up and running, feed it into your Buy and Hold machine. The other beauty of having a side business is that if you lose your job, you won’t be forced to sell your stocks at possibly the worst price ever. You can use the money from your side business to make ends meet at home for a while.
Your Side Business Needs to be a Cash Cow
The fact that you have a side business is great – you can feed the profits from that business into your buy and hold investment strategy. However, all of this is useless if your business is not a cash cow.
If your business works something like this, then it is not a cash cow company.
- It’s 2013. I signed one contract for $50,000, and it’s going to take me a year and a half to complete this contract.
- It’s 2015. I just signed another contract for $45,000, and it’s going to take me a year to complete this contract.
If the time lapse inbetween “cashflow” (Contract #1 vs. Contract #2) is a long time (in this case, over a year), then this is not a cash flow company. What’s wrong with that? Because if you look at Warren Buffett’s model, he buys a ton of stocks whenever the economy’s in trouble and other companies are cheap. However, he is only capable of doing this because his businesses are cash cows – they throw off a steady stream of income, meaning that when he needs to buy a company, he will certainly have the cash ready (his businesses always throw off cash). Here’s an example.
Your side business works off of 2 year contracts. Contract #1 started in early 2008. Contract #2 started in early 2010. That means you missed a window of opportunity in March 2009 when stocks were dirt cheap.
But if you had a steady cash flow, you would have been ready (time-wise) to buy when stocks were cheap in early 2009.
Maybe I am too dumb here, but how does having a side business really have anything to do with buy and hold? Basically all I am getting is that I am not Warren Buffett, which I am more than aware of.
I am also getting that you are saying that the average investor is smart enough to “time the market” by having cash ready to buy at good times. But if I remember correctly, you said earlier that you can’t time the market. So wouldn’t just dollar cost averaging be better? Or would I just be better off purchasing dividend assets like Mr Buffett loves? I guess I will just stick with what I am doing since it has worked for me so far and it worked for my dad and it worked for his dad and guess what? We all use Buy and Hold using mostly dollar cost averaging (of course my dad and grandpa had the advantage of living in through one of the greatest periods of economic growth ever).
The concept of ever increasing cash flow and a snowball effect occurs when you “buy and hold” great dividend paying companies for the long term. The same thing happens, dividends (cash flow) is used to buy more of the same business or another business and with each dividend payment you have greater cash flow allowing you to buy even more shares of the business.
DivHut recently posted…Dividend Income Update – April 2014
It’s funny how snowball is thought of in terms of debt like a Dave Ramsey and less like the Warren Buffett strategy of acquiring companies. It’s a strategy like Divhut mentioned can grow into more with your excess cash flow.
Even Steven recently posted…Only 12,000 Days till I Retire
Interesting – I never knew the method Warren Buffet used. It certainly seems to make sense.
Derek at MoneyAhoy recently posted…April 2014 – Money Making, Saving, and Investing Report
Some interesting ideas here, but the part that’s missing for me is the focus on a persons unique situation, goals, and abilities. I think to explicitly say ‘buy and hold doesn’t work’ is a bit extreme. Will it ‘not work’ for the young adult putting a little away each month to build up a nest egg for their children’s education in 20 years? Or as a safety net for their own retirement in 35 years? What about factors like how much of your earnings you’re putting into your buy and hold strategy? Surely putting 50% of your monthly income vs 2% are extremely different propositions. Buy and hold clearly worked for Brian above, and his family, so how can that be ‘wrong’?
If you’re talking about early retirement / financial independence / living off your investment income ASAP, then sure, buy and hold might not suit you. But I think blanket rules and statement like this are at risk of misleading people about what they should do, and what will work best for them (and we don’t need to be Warren Buffett to achieve our goals and life a great life!)
Always like to see different perspectives and ideas being tested and challenged though!
Jason @ Islands of Investing recently posted…How to save a poor investment