For a long time, I have advised against buy and hold strategies because they do not consistently work. There are many rational reasons why they do not work, but the biggest is due to economic fundamentals. For any investment to go up in value, there must be a sound economic fundamental reason that is forcing it up. If positive economic fundamentals are not present, then an investor will not receive any asset price appreciation over the long-term. Therefore continually buying and holding the same market blindly over long periods of time with the simple belief that all markets go up over long periods of time is never a sound investment philosophy.
When I voice this opinion, I am always hit with the same few retorts. The first of which is "if one invested in the S&P 500 20 years ago they would be up massively". The other, which is my personal favourite, is "If you are right, then explain how Warren Buffett became one of the richest people in the world based on buy and hold strategies". The best things about these counter arguments is that by answering them you provide clear proof that buy and hold strategies should not be considered as money makers.
First let's tackle the Warren Buffett phenomenon. Is Warren Buffett a buy and hold strategy user? Absolutely, but it would only be a part of his strategy. Warren Buffett does not arbitrarily or continuously buy the same asset or group of assets such as a broad market index and hold it forever. He buys assets that have very sound economic fundamentals. For Warren Buffett to buy a stock it must not only have sound economic fundamentals, but also be currently undervalued by the market. The reasons for any incorrect market valuation are numerous, but there are limited numbers of people who have the ability to take advantage of these mis-pricings, especially at scale. Any asset that Warren Buffett buys has many underlying economic fundamentals that made his investment a rational one. The best strategy to use as a result of these economic fundamentals is buy and hold, but only until the full value of the asset is realized. I am not saying anything new or ground breaking here. Warren Buffett's investment strategy is very well known. He would probably be the first to say simply buying and holding a market is not a sound investment strategy. For buy and hold to work, the investment must have sound economic fundamentals. He would also probably be the first one to say his investment style cannot be compared to a simple buy and hold strategy that so many investment professionals compare it to.
Now that the Warren Buffett phenomenon has been addressed, let's look at what if we had invested in the S&P 500 20 years ago. Would we have made money? Yes, for sure. However, would we have made money because of the buy and hold strategy, or would we have made money because we had sound fundamental economic factors? I would argue that the individual made money because of economic factors that brought the markets to new price levels. There is not an economist in the world that would not attribute the last 20 years of market growth to globalization, at least in part.
Thus, if you had bought the market 20 years ago, there is no doubt you would have made money. But an investor would have made money because of economic growth. Most profits were due to sound economic fundamentals and not simply because of the buy and hold strategy working. Despite this, far too many investment professionals continue to profess that over the long term all markets will have price appreciation, so the buy and hold strategy works. You may ask, what is long term? The maximum length of time anyone should look at market growth is the average investor's time period in the market. This means the average amount of time a person has to invest in their lifetime. Let's look at the 20-year time frame for example.
If buy and hold truly works, then in all 20-year periods on any given asset you should see positive returns after you index for inflation. For this analysis we will use the S&P 500. How many 20-year periods since 1915 have there been where the market is actually down or has a return on investment that is so low you would have been better off just leaving your money in a bank account? The graph below shows just that. Starting in 1935 and going back 20 years, it shows what your annualized rate of returns would have been. So, in this case an investor that had bought and held 20 years in the 1960's would have had a negative return on investment.
(click to enlarge)
From this graph, we can see that there are many times when a buy and hold strategy would not have worked.
Naturally we can look at other asset classes for diversification, and looking at just the S&P 500 in isolation is an unfair comparison. But is the average investor diversified? Global diversity simply is not a reality for the average person. The average investor knows the S&P 500 so that is what they invest in. The average investor is not diversified because he is naturally geographically biased to their home country.
Even if the investor is lucky enough to have geographic diversification, the investor still will run into times like 2008 where all assets globally are correlated and fall concurrently.
Buy and hold is an investing strategy that only works some of the time and in only particular cases. If your financial advisor is telling you to buy the market because it always goes up over the long run, you should ask them about the periods where the ROI has been negative. How would he guard against that? Being fully invested in an index without proper risk management or valuation analysis, is yet another tactic to keep you invested so they receive easy fees. For true diversification, buy and hold should be considered as just one strategy in an array of strategies. If your investment professional argues otherwise, you really should kindly escort them out the door and look for an advisor that offers alternative investment strategies.