'Buy and Hold' Is Alive and Well

We've heard many voices recently denouncing buy-and-hold investing, with claims such as “long term investment died as a thesis” this year. Of course, these voices are featured most prominently after a huge fall in the market, when the outlook for returns from long term investments has actually improved.

The best example of this is an infamous Business Week front-page story entitled “The Death of Equities,” published in August of 1979. Then, as now, investors were weary of a long, painful bear market. While that story didn’t mark an exact bottom in the market, in the two decades that followed the S&P 500 increased more than tenfold.

Valuations finally looking good

Robert Shiller, in his perfectly timed Irrational Exuberance (published in March 2000) made a strong case for stocks being wildly overvalued. That was a good time to question the wisdom of buying and holding stocks regardless of valuations. Shiller used a chart of P/E ratios that tracks a 10-year moving average for earnings to dampen the effect of earnings fluctuations on P/E ratios. At the time Shiller’s book was published, this adjusted P/E ratio was a record 43. This methodology of tracking the market has since been popular and is updated on Shiller’s web site:

As Shiller’s data has a lag of a couple of months, I decided to update his graph with the recent market action. By this measure, the market is cheaper than it has been since 1985. Rather than questioning stocks as viable investment vehicles, it seems to me that stocks are looking better than they have looked in over twenty years.

Earnings cycles

Many investors have raised doubts about P/E ratios as earnings have been unusually high in recent years, but now it seems clear they are destined to fall in coming years. When this happens, they say, the P/E ratio will rise again. The graph below shows earnings as a share of GDP since 1948. The earnings numbers are based on data from the Bureau of Economic Analysis (BEA), which is designed to be consistent over time and excludes capital gains and losses, for instance.

We can see that corporate profits were a relatively small component of GDP in the 70s and 80s, with a fair amount of time being spent in the 6% - 8% range. Recently, corporate profits have fallen from a peak of 12.9% of GDP in the third quarter of 2006 to 10.2% in last quarter. It is not hard to imagine profits falling further. How far this fall will be is anyone’s guess, but barring a Marxist revolution or a complete breakdown of the U.S. economy, 6% seems like a reasonable floor.

An earnings history for the last sixty years (from the same BEA data set as above) shows that overall corporate profits (shown here on a logarithmic scale) are not all that volatile. Besides, the value of stocks represents claims on their future earnings into perpetuity, so one very bad year should have a limited impact on valuations.

No reason to shy away from the market

The extreme volatility that has been prevalent in the market in recent months is disconcerting for those hoping to turn a quick profit on their stock purchases, but should not cause long-term investors much alarm. As discussed above, stocks are cheaper than they have been for decades. What makes the market even more attractive now is that interest rates are low, in stark contrast to the very high rates of the 1980s.

Far from being dead, the buy and hold investment approach is in good health.

Comments

[Cecil:]

You make some good points in this article, but I don't see how you can conclude that buy and hold is alive and well. What would you say to the people who bought stocks 11 years ago, and have absolutely nothing to show for it?

2008 Nov 24 09:43 AM

[User 13958:]

Interesting comments in this article. I have been a buyer of DRIPS--more "buy-and-hold" than trading constantly.........wha... alleviates my current "suffering" is the fact that most of my DRIPS are paying me a dividend.
Dividends helps as share prices plunge.....to-date i have not had any bankruptcies in my holdings.......I will kep my "fingers crossed",,,,,
I will work a bit longer, and, pray that we start getting out of this financial mess by end-2009.

2008 Nov 24 09:56 AM

[The Hern:]

I guess we can all hope that "buy and hold" will now be a viable strategy but most funds 10 year return is presently below money market yeilds. It is too late now for any buy and holders to sell now but the market performance better improve or "buy and Hold" will go the route of the dinosaurs!

2008 Nov 24 11:17 AM

[Chuck LeBeau:]

Buy and hold might work if you are a Warren Buffett and never need the money. But most investors will need to cash out sooner or later and the money needs to be there. Where would you be if you invested ten years ago and needed the money today?

Granted that this might be an excellent time to be a buyer but if you had sold a year ago you could be buying a lot more today.

Buy and hold does nothing to control risk and its reward is questionable.

2008 Nov 24 04:51 PM

[Les Masonson:]

Your article does not really address the issue of risk of losing money in bear markets. Buy and hold is DEAD, especially with 2 crashes within 8 years. Get real and use a mechanical investing approach that has been backtested.

2008 Nov 24 06:45 PM

[Lara McR.:]

It seems to me that the old Buy and Hold has proven its limits.
It has proven its limits crashing down in flames

Would you "Buy and Hold" if you knew that a financial storm is coming?
No, you will dump as quick as you could.

Buy and Hold is only as good as the recovery of the market, unfortunately it takes a 333% increase to recover a 70% loss.
How long before the market increase 333% or 150% ? Can you tell?
- I can not.
I am going to quote someone, and I found his analysis very pertinent to the subject: "Buy and Hold is not a Strategy. Buy and Hold is the absence of a Strategy."

The author of that quote published an article in this website. google it.

In the mean time, I hope that everybody will recover

2008 Nov 24 08:22 PM

[Mr. Boater:]

Your subject is foolish and naive.

"Buy and hold" was never heard of until the late 70's when the Wall Street Sharks got with the large corporations and discussed a new way to gain control of pension money in order to churjn and burn and otherwise bilk the unsuspecting little guy who had not the slightest idea how to manage his pension money.

Using the Ibbotsen and Sinquefeld study of the late 70's that found the"long term" return of the market to be close to 10%.

Armed with this piece of biased information--nobody was told at the time most of the returns were based on dividends--the corporations saw a way to get out of managing defined benefit plans,

Wall Street licked its lips, and they went and lobbied a bunch of stupid congressmen-[are there any other kind?] to pass laws defining IRA's and 401k's, sending innocent workers futures to the blood suckers. "Retire a millionaire" that was a big one I heard on a Wall Street firm's TV ad. Remember that one?

Thus "Buy and Hold" was born. If one buys and holds, how does one buy low and sell high? Money is made in the mid-term--and don't you all forget it. The wisdom of the old codgers is called Wisdom for one reason --IT WORKS--MOVE TO THE SIDELINES------

2008 Nov 24 10:01 PM

[AnnaH:]

Great post, some very strange comments. It looks like everyone has the benefit of hindsight, but no one is willing to look further into the future than a few months.

Lara, being successful in long-term investing does not require perfect foresight or the ability to predict exactly when certain events will occur, such as crises or when the market has increased by x%. No one has that ability. Of course you can have shorter-term strategies within your longer-term investment time frame to hedge your bets if you suspect things might go sour for a while. Also, no one would recommend that you hold if you have lost faith in the fundamental value of your investment.

Mr. Boater, "Your subject is foolish and naive.... Money is made in the mid-term--and don't you all forget it." Money is made in the mid-term, what does that even mean?
Why do you think the subject of long-term investing is foolish and naive?

It seems like some people can barely grasp the concept of investing, let alone distinguish between trading and investing.

Apparently those same people have lost faith in the profitability of companies in general and/or equity as a viable way to share in those profits. This is extremely short-sighted and very difficult to rationalize.

I suppose we also saw the death of equities in 1979?

2008 Nov 26 04:01 PM