Bad news for the ghosts and goblins – 3D value investing outweighs the Halloween strategy.
“Halloween, Halloween Strangest sights I have ever seen, Witches hat, coal black cats, Ghosts and Goblins, Mice and Rats, Halloween, Halloween, Strangest sights I have ever seen!"
On the night of the 31st of October, we witness a range of bizarre affairs. But who takes the cake for the strangest of them all? In my opinion, the investors following the Halloween strategy.
The Halloween Strategy
The Halloween strategy, commonly referred to as the “sell in May then walk away” strategy, is an investment technique in which an investor sells stocks before the 1st of May and doesn’t re-enter the market until the 31st of October. It is based on the idea that stocks perform better during winter months as opposed to summer months and focusses on short-term capital gains.
Let's look at the components of an investment strategy to consider and compare how they differ between the Halloween strategy and a 3D value investing approach.
The Halloween Strategy vs. 3D Value Investing
The major concern around the Halloween strategy is the fees and taxes involved with frequently exiting and re-entering the market. Selling your entire portfolio and recreating it all on a yearly basis, is a lot of investment activity. Transactional fees and taxes accompany every trade you make. It can become an expensive ordeal, and you could run the risk of outweighing your gains with unnecessary fees.
According to TurboTax, In the U.S., short-term capital gains are taxed at the same rate as your ordinary income. You don’t benefit from any special tax rate. For 2015, ordinary tax rates range from 10 percent to 39.6 percent, depending on your total taxable income.
On the other hand, you can benefit from a reduced tax rate on your profits but only if you hold your assets for longer than a year. For 2015, the long-term capital gains tax rates are 0, 15, and 20 percent for most taxpayers. For high-income taxpayers, the capital gains rate could save as much as 19.6 percent off the ordinary income rate.
How do you avoid paying investment fees? By staying in the market. Holding your assets incurs no fees, no taxes and actually reduces your tax rate.
Taking the past performance of the S&P 500 into consideration, there are years where the returns generated by the Halloween strategy outperformed the market index, but you simply have no guarantee that it will work in the future. Basing your strategy on the season is akin to speculating. It is merely a theory without any guarantee.
Adapting a buy-and-hold, 3D value investing strategy is less volatile because you trade less, you invest with a margin of safety, apply fundamental analysis and you only pick stocks based on sound business principles. Although the market may experience seasonal fluctuations, we are happy to hold our businesses for the long-term.
Another simple point is dividends. If you are not in the market, you may be missing out on valuable dividend payments. Dividends are important to investors because they substantially increase profits and often offer tax advantages.
Even with all of the benefits, many investors fail to see the massive impact dividends have on investment gains. According to Investopedia, since 1926, almost half of the S&P 500’s profits can be attributed to dividend payouts. Meaning that the inclusion of dividend payments has roughly doubled the returns of stock investors, compared to what their returns would have been without dividends.
If you buy-and-hold dividend stocks, you take advantage of all its benefits and the huge impact it has on your returns. Why would you want to miss out on dividends?
It is all about the quality of the stocks you pick.
If you simply track the S&P 500, the Halloween strategy would have resulted in higher gains in 2015. But we don’t believe in tracking broad market indexes. We only invest in diversified value stocks at a margin of safety.
Although the broad market indexes were down, individual stocks still performed extremely well. Let’s take a look at Admiral Group Plc (LON: ADM) and WH Smith Plc (LON: SMWH) for example.
Source: Google Finance
Between the period of May 1st and October 22nd, a buy-and-hold investor would have been paid £1 in dividends and would be up by 7.21%. Which means the total gains would have been 13.8%. If you factor in the fees that a Halloween strategy investor would have paid to sell the stock, you are looking at a potential loss of anything between 15% and 20% over the period.
Source: Google Finance
Between the period of May 1st and October 22nd, a buy-and-hold investor would have been paid £1 in dividends and would be up by 17.24%. Which means the total gains would have been 18.24%. Selling in May would have cost you 25% in profits.
Picking quality businesses and holding them for a long period will achieve higher returns than removing yourself from the market for six months every year.
To put it into perspective, we compare the buy-and-hold strategy with the Halloween strategy, using the STRIDE model over a period of three years with a starting balance of US$1,000,000.00.
The buy-and-hold strategy amounts to a total gain of 55% over three years, compared to 30% achieved by the Halloween strategy. Not only would the Halloween investor be trailing by 25% in total returns, but would have dedicated much more time, effort and stress into investing.
The number of trades you would have made by buying and selling according to the STRIDE engine would have been 200, compared to 59 trades made by a value investor. Activity is expensive. With every trade costing you $15, 15% income tax and 20% capital gains tax, you can expect to see it eating away at your profits.
Never mistake speculation for tangible investment tactics. Investing with the hope of outperforming the broader market index is a strategy I would never recommend to anyone.
Picking the correct value stocks will generate great returns all year round. Buying and holding those investments, reinvesting your dividends and taking advantage of compounding interest will boost your portfolio tremendously.
The buy-and-hold strategy is a win-win situation. You save time, effort and stress, and you achieve much better returns in the long-run.
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