How to Avoid the Stock Market's Graveyard

I’ve written recently about the fatal flaws of the buy-and-hold investment philosophy. Namely, the strategy’s success requires something that most investors simply can’t muster: an unwavering commitment to “hold” for an unimaginably long period of time (many decades).

What’s more, the strategy fails to include a safety mechanism – something that ensures investors won’t lose all of their money.

That means investors are left to their own devices when it comes to managing risk. And a number of studies within the realm of behavioral finance are revealing a troubling truth: investors are not good risk managers. In fact, we are our own worst enemies.

But there’s one more argument I want to make in favor of capital preservation, which I’ve suggested is the “missing piece” to a buy-and-hold strategy.

You see, proponents of buy-and-hold tell a little “white lie” about the strategy’s track record. But there’s a devil in the details, one many investors fail to account for.

And that “devil” is present all over the stock market’s graveyard…

First, here’s the party-line for buy-and-hold:

“Since 1950, an investment in the stock market (S&P 500) has never produced a negative return, when held for at least 20 years.”

Stay invested long enough… and the stock market will always climb higher, because it always has.

This echoes the same argument we hear for real estate: “Over a long enough time horizon, home prices have always gone up.”

Baked into this argument is the expectation that home prices will never go to zero. And, likewise, that the S&P 500 will never go to zero.

Ok, so here’s the problem with this argument…

It speaks to the overall market, not the individual companies inside it.

It’s true that the Case-Shiller Home Price Index (which represents the nation’s housing prices) has a long-term upward bias. And that, more importantly, it will likely never go to zero.

But that doesn’t mean that individual houses, in individual cities, can’t go to zero. In reality, many have.

Just look at Detroit, Michigan – where whole blocks of houses can’t be sold, even for prices as low as $500 (practically “zero,” in my book).

Alas, the very same logic applies to the stock market, which contains thousands of individual companies.

Yet, many of those companies have indeed gone to zero.

Now, I firmly believe that the S&P 500 as a whole will never go to zero.

But the S&P 500 – which many consider “the stock market” – is comprised of 500 individual companies, which can, and do, get kicked out.

Worse, some companies get delisted – meaning they aren’t allowed to trade on any U.S. stock exchange, like the New York Stock Exchange or the Nasdaq.

Over the years, tens of thousands of individual stocks have suffered this fate.

Mind you, these stocks haven’t officially gone to zero, but they might as well have. Institutional investors, credit rating agencies and retail investors simply won’t touch them with a 10-foot pole. And the only ones who do are pump-and-dump hucksters on the Internet and the foolish gambler-investors who take their bait.

But some stocks do go to zero. When that happens and the company goes bankrupt and completely out of business, they leave investors with shares of stock that aren’t worth so much as the paper they’re printed on!

So please… let this sink in… individual stocks do go to zero.

As I see it, that’s a harsh reality that the buy-and-hold strategy completely fails to acknowledge.

And it’s precisely the risk that a capital preservation strategy works to mitigate.

Recall last week, when I shared one simple capital preservation strategy:

Rule #1: Buy-and-hold, but only if the stock market is above its 200-day average.

Rule #2: Sell stocks (move to cash), if the stock market is below its 200-day average.

Applying this strategy to individual stocks, too, is a foolproof capital preservation strategy. I’ll give you a couple recent examples to show this in action…

On September 29, 2015, clothing retailer Aeropostale (NYSE: ARO) announced it is now at risk of being delisted (read: kicked out of the New York Stock Exchange), because its share price is under $1.

It’s currently trading for just 57 cents… even though in late-2013 it was worth more than $17!

But anyone who would have followed the simple capital preservation rules above should have sold shares on August 9, 2013, when shares were trading for $13.50 – below its 200-day moving average.

If they had, they would have avoided the 95.7% loss of capital the stock has suffered since!

One more…

ZaZa Energy Corporation (OTC: ZAZA), an oil exploration and production company.

This one was actually just delisted – on October 2, in fact.

As its listing shows, the stock is now trading “over the counter (OTC)” – where only the bravest (or most foolish) investors will touch it.

Whereas shares are going for a mere 23 cents today, they were valued at $37 in July 2012, when our simple capital preservation strategy recommended selling the stock.

Here, a capital loss of 99.4% was completely avoidable!

These are just two examples, but there are thousands more just like them. And most investors who work to build a long-term “buy-and-hold” portfolio simply fail to account for this.

And to think, all you have to do to avoid it is follow two simple rules…

To good profits.