Is 'Buy and Hold' an Antiquated Theory?

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% annually...an 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?

Comments

[wildfirexx:]

You're forgetting that a 50% Bounce in the market is not the same as a 50% Drop. The Dow has dropped from a high of approx.14000 to a low of approx.7000 (roughly 50%) but would have to recover by at least 100% in order to reach 14000 again.

Mar 03 07:14 AM

[Jim Hawthorne:]

'Buy & Hold' is not a theory; it is an investing strategy.

You state; '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.'

Wow! I find this an odd statement in view of the fact that so few mutual fund managers manage to beat the market consistently!

Along with Bloomberg and Morningstar, MarketWatch reports that, 'Mutual fund investors in 2008 yanked more money out of actively managed stock-funds than they put in for only the third time ever, and index-fund rivals took the spoils.'

This indicates again that actively-managed mutual fund managers aren't doing much great work at all, a fact clearly demonstrated by their clients' move into indexed funds!

'Buy and Hold' is just one of many investment strategies. It may be suitable for some investors in some economic environments while being totally unsuitable for other investors with different goals, risk profiles, abilities and inclinations. There is no 'one size fits all'!

Many of us have successfully employed strategies ranging from 'buy & hold' to 'active swing trading' to 'day-trading', and even a 'sitting it out' strategy 100% in cash. We can spend days arguing back and forth about the relative merits/shortcomings of any and all of these in different time-frames and positions in the business cycle.

The simple truth is that if you engage in ANY investment strategy that is at odds with current market conditions and sentiments, or economic realities or is just plain out of sync with your goals, skills, abilities and predisposition, then you will most likely fail.

Post 1999, buy and hold worked well from spring 2003 through spring 2007. In other time periods, the flexible and nimble trader fared better; and there were even times that cash was king. Right now, cash still looks pretty good to me!

Mar 03 07:23 AM

[Crude Oil T...:]

This is nothing new, buy and hold has been dead for years. Ask anyone who has had a market correction land on their retirement date/time frame. Brokers that invest clients money in stocks for the long term while trading indexes with the trends in their own accounts should be put out of business.


stock-market-club.blog...

Mar 03 08:30 AM

[pokernut:]

I sold all my stocks and switched to cash and fixed income when the DOW hit 13,800. I now own 2-year CDs paying 4.3%. Will buy stocks again when the DOW hits 3500.

Mar 03 08:38 AM

[cannedpawn8:]

Right on wildfirexx...

Mar 03 09:13 AM

[kelm:]

Good article.

The bottom line with any strategy is whether you make money with it over the long run. As pointed out above buy and hold has done rather poorly in the last decade. What is most worrisome is the number of people who sit through it taking bigger and bigger losses but who have been so brainwashed that you "buy and hold" that they will not sell.

There is no substitute for reading a good financial newspaper daily and thoroughly. Everyone can make time for that. Then make your own decisions. Mutual fund managers and investment advisers have done an almost criminally poor job of managing their clients through this. I expect none of them really read anything thoroughly either.

Mar 03 09:17 AM

[pacman1947:]

"Catch a falling knife and put it in your pocket," pardon the slight adjustment of the lyrics, is the advice you offer here. Wait for the knife to hit the floor. Using another metaphor, we may have a "dead cat bounce" when this market hits bottom. The worst thing you can do is to fall into the "bear trap" of a short knee-jerk rally after the fall we have seen so far. We've seen almost none since 2007 that lasted for more than three days.

I would not want to be a broker in this world unless my specialty were options trading. Oddly enough, I discovered that options traders lose about 85% of the time. Gambling is a better profession.

I've invested in all markets since 1969 when I came of age. I've never seen carnage of this magnitude. Giving advice to those who have already taken the beating would be difficult at best. There may be a recovery just around the corner, but maybe there will be Armageddon.

Buffett made a call a few months ago, and he paid for it. I don't think he's right to make another call today. If you've taken the losses you may want to sit out the ride and see what happens for a while. If you're still all in, stay in. The upside potential may be worth the risk relative to the downside.

That's the decision you make every day if you're an investor.

Mar 03 09:59 AM

[max12345:]

The most worrisome aspect right now for those who are "in", is not just how much further down markets can or will go. After all they can only go down to zero. (so people's life savings can be wiped out, but we can't all also end up in debtors prisons) (which is certainly a definite plus)

It is how long it will take (if ever) for markets to go back up again to where they were just one short year ago...or even 30-40% shy of that, to a Dow of 10,000 The assumptions made in the article is that markets will rebound. This assumption is probably true. The real question is when will they do so, and how long will it take? 10 months, or 10 years?

That is, will we see that "V" or will we see an amazingly long and protracted "L"? And just how long of an "L" is "amazingly long"?

Unfortunately there is no reason to automatically assume or believe that markets will go up by the 100% that it would take (pls. see the very first comment above, which is correct) to just return back to where they were a year ago.... in either 10 months, 10 years, or for that matter, even in 30 years.

And "historical" data (history does NOT always automatically repeat itself) is largely irrelevant since we have no way of knowing (with any real certainty) if this is a recession, a depression or the global catastrophe of the century in the slow making. (or the fast making and the slow unmaking)

I certainly hope that within six months assorted clairvoyant positive thinking people will be smiling knowing smiles at my silly comment, but at this time I do wonder.

Mar 03 10:52 AM

[Fred Voetsch:]

"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!"

Foolish.

It is not a theory but it is reality that told me and many others that it was time to sell in 2007 and that it is still not time to buy.

Housing is accelerating its decline and shows no signs of a bottom and the best minds on the subject suggest we are a year or two away from hitting a bottom and that the recovery will not be rapid.

Banks still have much deleveraging to go through and it is obvious that no plan has been put in place to provide true stability.

The consumer has just started to get it and has begun saving once again with an eye towards paying off debt accumulated over decades. Those same consumers are watching any wealth they had be destroyed as the stock and housing markets tumble. Their view of life has been forever altered and they will not go back to spending the way they once did.

Need I go on? These are not theories.

Buy and hold investing will make a comeback and a young person would be wise to start investing in this market (housing or stocks) now, as long as they continue to invest over the course of their life.

For baby boomers and anyone else evenly remotely close to retirement you need to understand that this market can and will drop thousands of more points and that means another drop of 50% and then maybe another 50% drop. The upside is limited given the damage done and the demographics over the next 10-20 years but the downside could be catastrophic to your portfolio. Watch the Leading Economic Indicators and listen to wise people like Nouriel Roubini, Meredith Whitney and Louise Yamada and once you see some light at the end of the tunnel start dollar-cost-averaging into the market and don't try to make up what you lost all at once.

Mar 03 11:30 AM

[Mike Picone:]

I like this article and, because of the quantitative approach, find it very helpful. Based on the Ibbotsen studies, I only recommend buy and hold for those with a 20-year holding period or longer. As the horizon shortens from 20 years, I recommend a strategy that directly recognizes the nonnegligible, though small, probability of an event such as the one that we are currently experiencing. This is because the adverse effects of such an event become much more likely to be permanent as the time horizon shortens. Ibbotsen shows that a 20-year period has always produced positive returns for stocks, even including a period starting with 1928. The late Al Frank, the Prudent Speculator, showed similar results from his own investments.

Mar 03 12:08 PM

[ain't no fo...:]

I grow weary of hearing the same carrot tossed out to the sheep as an enticement to stay invested for the long run. Always the tease that you will miss the great move back up if you get out:

"...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?"

I heard it at Dow 14K

I heard it at Dow 13K

I heard it at Dow 12K

I heard it at Dow 11K

I heard it at Dow 10K

I heard it at Dow 9K

I heard it at Dow 8K

I heard it at Dow 7K

I'll stop day trading and buy shares for the "long term" (two weeks? a month? 2 months?") when the soothsayers stop screaming "Buy and Hold"... because what they're really saying is "Buy and HOPE".

Mar 03 12:10 PM

[max12345:]

It's fine to be pessimistic and stay out of the U.S. stock market. But some of the analyses in the comments above seem to reason as if only the U.S.A. existed. Not all consumers around the world are in debt, not all banking systems are in shambles and not all countries have built up massive debt. For instance Australia and Canada (but not only those two) are not nearly in as bad a shape as the U.S. Could it be that enough other countries will turn around (by stimulating internal demand) even if the U.S. and Europe don't? And might not selected Australian and Canadian stocks be at bargain basement levels? So how about "buy and hold" the right stuff instead of the wrong stuff? Instead of "don't buy and don't hold anything" which might seem just a bit less wise in just a year or two?

Mar 03 12:32 PM

[a. palmer jr.:]

In an Edward Jones commercial on television they stated that they support the buy and hold for the long term strategy. I haven't seen that commercial for awhile.....

Mar 03 05:58 PM

[MauDib:]

Buy and hold works in only one case: businesses increase dividends, not cut them, to encourage investment in their company. Like buying a CD, that encourages families to save now because of increased consumption in the future, not just a hoped for promise of capital gains.

Of all the stakeholders in a business, e.g. govt taxes, employees, etc., the distant owners get the least and the last, meaning after everyone else gets their cut - the poster child is GM.

During this decade, I read financial commentators talking about a "mouth-watering" 3 % dividend - you have got to be kidding! Give the shareholders a real return on their investment since mgt does not need the cash for growth (and growth for its own sake - questionable benefit). How about a real return: spendable cash to me of 7% on my stock price!

Mar 03 08:37 PM

[Moon Kil Woong:]

Usually those professing buy and hold are simply lazy and or ignorant. Often it's a broker who doesn't want too many phone calls and can't remember what you're holding. Why do you think even the Dow representing the large caps change their stocks over time?

Mar 03 11:19 PM

[malach hamo...:]

Pick any market strategy other than having next week's newspaper today and it's been totally discredited over the past year.

Buy-and-hold leaves you with Citi @ 1.20 per sh.

Mar 04 04:32 AM

[plumstupid:]

Another comment above sized it up very well. The one about lazy brokers..

Mar 04 07:30 AM

[speculari:]

Jim Hawthorne's comments have got it just about right, as far as I'm concerned. I would only add that the mantra regarding diversification is also another oversold practice. Mark Twain once said "Put all your eggs in one basket... and then watch that basket very carefully." Twain may have been far better as author/raconteuer than investor - but, the point is clear. Right now, cash is king... or, whatever keeps your particular boat afloat!

Mar 04 09:45 AM

[Marianthi:]

Buy and hold left my grandmother with 400 shares BAC at $3.60. No thanks!

Mar 04 02:26 PM