Is 'Buy and Hold' an Antiquated Theory?

 |  Includes: DIA, QQQ, SPY
by: Muizz Kheraj

Well, we finally did it - we've sold off 50% from the S&P highs held just 9 months ago and there is still widespread fear all around that lower is the next stop. "ZERO" is the new mantra of the many hundreds of thousands that have seen their investments and retirement savings cut off at the waist. The joke around the water cooler is not how your 401k is doing, but whether you've liquidated your "201k."

Sadly, this is not a joke - many retirees are in a shell-shocked state, seeing their lifetime of savings halved in the blink of an eye. Unfortunately, these retirees were given incredibly inappropriate financial advice or believed (as did many of us) that the party on Wall Street would never end and they wanted their cake too. Those close to retirement should have been primarily in bonds over 10 years ago and out of the market completely over 5 years ago. Although this is a recommended asset allocation which serves to protect you from a nasty downturn, in fact, because Treasuries outperformed equities over the last 10 years, this asset allocation would have been better for all of us, not just retirees.

So what's next? Do we all go an cower in the corner til the sky falls and then rebuild? Should we all be going to cash - selling our holdings in investment and retirement accounts, here at S&P 700?

This is what many so-called experts will tell you - that "Buy and Hold" has ended and been a laughable strategy invented in the 80's as the boom market took off; that no one in their right mind holds a stock forever.

Well, they are right ... partially. No one holds a stock forever - no one should. Companies have their own life cycle, and while they are growing or even in saturation stage (some companies stay at the saturation stage for a long time - see MSFT), they are absolutely worth owning. When business starts going south, then it is probably time to sell. But how many of our 401ks are in individual stocks? How many of our investments are? The answer here is pretty clear - almost none. By and large, most investors, even today, continue to invest in mutual funds, which certainly explains how this multi-trillion dollars industry thrives, even today.

Mutual funds are managed holdings of a diverse basket of stocks. The key word here is "managed." Mutual fund managers buy and sell all the time.... so that WE DON'T HAVE TO. If we buy and hold, we continue to allow mutual fund managers to continue their good work, which is identify and buying great companies, while selling underperforming ones.

I recently analyzed both the S&P 500 and the Dow Jones Industrial Average (DJIA), two broad market indices that most investors look to as their pulse of market health. I wanted to test the "Buy and Hold" theory on these broad indices which many of us invest in through indexed mutual funds, such as the Vanguard 500.

Taking an investor, say Investor A, who purchased $100,000 every month in each index, I tracked how that Investor A's annual return would look had he invested every month for the past 10 years. I then looked at how another investor, say Investor B, performed had he begun to invest just one month prior to Investor A and looked at his returns over a 10-year period...and then I went back every month and retested this investment strategy, back to January 1960 for the S&P 500 (this investor was invested for the 10-year period starting January 1950) and back to January 1939 for the DJIA Investor (this investor was invested for the 10-year period starting January 1929). The results of this analysis is startling.

First, the S&P (note that red line indicates average 10-year return):

Next, the DJIA:

Notice anything interesting?? Just as people were ready to throw the theory of "Buy and Hold" out the window, as they likely wanted to do in 1942 as their annual returns looking back 10 years were almost -2% or in mid-1974, as their annual returns looking back 10 years was almost at -4%, the trailing returns began to sharply recover. In 1942, it was the war effort that re-ignited the economy and in mid-1974, Nixon had just resigned and the DOW (and S&P) staged a horrific collapse over 2 months of over 25%. Newsweek, in one famous call, quipped "Is there no bottom?"

Well, we are at about that same place now on the charts above. In terms of market bearishness and annual returns for investors looking back 10 years...this is worse than it's ever been. An investor who began investing monthly in the S&P 500 10 years ago, is down 5.06% incredibly depressing figure and one that has the "Buy and Hold" bashers dancing in their bomb shelters. Shockingly, the S&P is down 26% in just the last 2 months (echo, echo, echo...)

So what happens next...this is anyone's theory. It could get a lot worse (as everyone will quickly tell you)....or this is just the time when you should NOT be looking to get out, but actually looking to get invested and quick! One minor note for those DEBATING whether to get in now...or wait...investors who jumped in at this same low point in 1974, saw returns over the next 10 months (as the market rebounded sharply) of 31% annualized...those who jumped in 1 month early, saw returns of 28% annualized. "Buy and Hold", anyone?