5 Things to Consider Before Buying and Holding

For most investors that seek to actively learn about the trade, one piece of advice seems to come up over and over: "invest with a long-term horizon". There are certainly many good reasons for this. For one, it is much easier to see and predict long-term business trends and advantages then it is to predict what is going to happen over the next few months or weeks (in most cases). Investing with a long-term horizon also prevents unwise speculation, avoids paying hefty commissions and taxes, and focuses the stock investor on the business fundamentals - financial health, growth potential, competitive position, price - that are key to finding winning investments.

There is tangible proof that, over the long term, investing in stocks provides the best returns of any investment vehicle. Jeremy Siegel, a Wharton professor and well known financial commentator, showed in his book The Future for Investors (MagicDiligence review) how value-based strategies such as the Dow 10 ("Dogs of the Dow") and dividend re-investment outperform the market over long periods of time. In his other, and more well-known book, Stocks for the Long Run, Siegel goes all the way back to the early 1800's to show how stocks have outperformed bonds and commodities handily over long periods of time. John Bogle, the founder of Vanguard, made his fortune espousing an indexing strategy, showing how over the long run the stock market has provided about 10-12% annual gain on investment (The Little Book of Common Sense Investing is a short, sweet read on his philosophy). No less an authority than Warren Buffett has said that "forever" is his favorite stock holding period.

This wave of evidence and advice have led many investors into the "buy and hold" philosophy, where stock purchases are made with the intention of holding for 5 years or longer. But what is often not said is the risks of following a 5+ year "buy and hold" strategy with stock picks. The purpose of this article is to balance out the popular conception of this strategy of investing - not necessarily to discourage it. So, here are 5 important things to consider before committing to "buy and hold":

1) The Historical Rationale is not Practical

Siegel used a period of 100+ years in his first book, and over 50 years in his second book to justify his claims of indexing or using value based stock strategies for investment. Bogle and his ilk have routinely cited an 80-year average of market returns as justification for buying and holding index funds. These much publicized studies have ingrained in a lot of people's minds that "the stock market returns 10-12% over the long term".

That may be true... if your investment horizon is 75 years. For most people, 20-30 years is a more normal period for active investment, and the stock market has returned wildly different annual percentages over any given 20 year period. For the last 20 years, 1989-2009, the S&P has returned about 8.5% after dividends, through both a wild bull and depressing bear market, below the long-term averages. For the 20 years 1962-1982, it returned about 4.5% annually after dividends, not much above the return on fixed assets and well below inflation.

2) Investor Complacency

The psychology of long-term investing is sometimes described as "buy and forget". You do the research, decide that a firm has excellent long-term prospects, buy the stock with the intention of holding indefinitely, and then go do something else. Bad news is blown off because you think "it's okay, I'm in it for the long haul". In the meantime, while you are not looking, your company may be losing significant competitive ground or falling behind in business trends in its industry. The long-term attractiveness of the investment is deteriorating along with the stock price. Former long-term shareholders of mall lynchpins like Montgomery Ward and JC Penney (JCP) can attest to the damage done to an investment when firms lose touch with trends in the industry.

3) Less Chance to Fix Mistakes

This one is simple. If you are, say, a Magic Formula investor with a 1-year holding period, if you have a losing pick you sell it right before the 1 year is up, take the tax break, and move on, trying to buy a better position for the next year. However, if you are a dedicated long-term holder, and you make a mistake, that mistake is going to cost you gains for several years before you finally get fed up enough with investment losses to sell it. In the meantime, you've not only given up money, but time to earn those losses back. In investing, the miracle of compound interest needs time above all else to work its magic and build you wealth.

4) Holding Overvalued Stocks

On the flip side, another thing that long-term holders do too often is to hold overvalued positions. You buy a great company at a cheap price and within a year are sitting on 50% gains - but the stock is now over-valued. But you don't sell... your favorite holding period is "forever", remember... and the company still has good growth prospects. Thing is, those growth prospects are already priced into the stock. The forward prospects for gains in the investment are not nearly as attractive as they were when you bought.

This phenomenon is easily illustrated with almost any tech bell-weather. Take Dell (DELL) for example. You could have done great research and realized Dell's direct selling, low-capital model was a winner back in 1998 and bought in around $20. Your holding would have skyrocketed to nearly $60 by the end of the decade. It was now overvalued, but hey, there were still great growth prospects for low-cost PCs at that point, so you held the position. 10 years later, Dell is selling at just over $15 and you've lost not only your gains but 10 years of compounding interest as well.

5) Start and End is All That Matters

In investing, two things matter: where you start your investment and where you end it. It really doesn't matter what the period in between looks like. If you buy your investment when prices are high and sell when they are low, you get slaughtered no matter how long you held the position (in fact, the shorter the better). If you buy low and sell high, you win, again no matter how long you held. Folks who got caught up in market mania in the late 1990's and piled into index funds (which were highly promoted) have made exactly nothing over the past decade. On the other hand, those who piled cash into the market last winter when panic ruled are sitting on 40% gains in about 8 months. Start and end are all that matters - what is in between doesn't matter nearly as much.

The Point

The point of this article is not to discourage long-term investment horizons or promote short-term ones, but to show that the duration of a stock holding is unimportant as a core strategy. Instead of focusing on how long you plan to hold a stock, focus instead on whether the business is an excellent one and whether the stock is undervalued against past and reasonable estimates of future earnings. If you do this, the gains will take care of themselves.

Consider also looking at Joel Greenblatt's Magic Formula Investing (MFI) strategy. The tenets of this strategy are just as described - find excellent businesses (those with high returns on capital) selling at cheap prices (high earnings yield), and buy them. Hold them for a year, and then refresh with new positions that meet the criteria. This avoids a few problems with the long-term holding strategy, mainly complacency and holding overvalued stocks, all while giving you ample opportunity to fix mistakes with fresh gains. Combining Greenblatt's proven mechanical strategy with the analysis grunt-work provided by MagicDiligence gives you the best chance to vastly outperform the market over any investment career.

Disclosure: Steve owns DELL

Comments

[La Marque]

Good article!

Points 3 & 4 are hard lessons to learn. What keeps some 'buy and hold' investors in stocks is the tax consequences. Point 5 makes some investors to become momentum investors.

Good value gets the investor paid over the long haul a la Buffet. Dividends count in total return with a hope for some stock appreciation.

2009 Oct 18 09:29 AM

[MILESCFA]

Excellent article.... my one instablog makes the same point using charts and important referance material (CrestmontResearch.com). This is NOT a buy and hold market... but sometimes it is...

seekingalpha.com/user/...
...

2009 Oct 18 09:42 AM

[VennData]

The idea that "For one, it is much easier to see and predict long-term business trends and advantages then it is to predict what is going to happen over the next few months or weeks." is comical.

Prove it.

This is just more Wall Street marketing (aka give me your money to invest for you.)

2009 Oct 18 02:50 PM

[buoy]

Predictors are more confident if their predictions aren't expected anytime soon.


On Oct 18 02:50 PM VennData wrote:

> The idea that "For one, it is much easier to see and predict long-term
> business trends and advantages then it is to predict what is going
> to happen over the next few months or weeks." is comical.
>
> Prove it.
>
> This is just more Wall Street marketing (aka give me your money to
> invest for you.)

2009 Oct 18 03:43 PM

[MagicDiligence]

How many straight traders are on the Forbes 400?


On Oct 18 02:50 PM VennData wrote:

> The idea that "For one, it is much easier to see and predict long-term
> business trends and advantages then it is to predict what is going
> to happen over the next few months or weeks." is comical.
>
> Prove it.
>
> This is just more Wall Street marketing (aka give me your money to
> invest for you.)

2009 Oct 18 05:19 PM

[consumeronstrike]

Capital appreciation isn't everything. You're totally ignoring the fact that millions of people are dividend investors. We don't buy to sell...we buy to KEEP! At least I do. I will only sell if my investment's ability to maintain or increase the dividend seems in imminent danger of being impaired, if free cash flow is slipping, etc. A nowhere market? Fine with me! Is my company's business still sound, is business still good, is its competitive advantage still strong, is it still a market leader, is it maintaining a solid balance sheet and inventories aren't constantly increasing and maintaining financial discipline and allowing itself to become overleveraged? PG has raised its dividend for I think 56 straight years now. What kind of yield on cost would someone now have that bought it 30 years ago? Should this person (who would most likely be living VERY high off the hog on those dividends by now) be thinking, "well, I don't know...maybe I'd better sell now..." knowing without a doubt that PG's ability to pay those wonderful dividends is not threatened in the least anytime soon? I don't think so. Is this person going to panic during some market fiasco such as we had last year? People will still have to buy groceries, no matter what the stupid market's doing. His dividend checks will still arrive. His success depends on the company's ability to make money, not on how the stock does. Either you are a gambler speculating on capital appreciation or you are an investor buying a piece of the business. I know what I am.

2009 Oct 18 05:21 PM

[Old Trader]

VennData,

All that needs to be done is to take a look at a chart than covers a few years...either a given stock, or an index, and its not terribly hard to see if a trend is in place, and if so, which direction its taking.


On Oct 18 02:50 PM VennData wrote:

> The idea that "For one, it is much easier to see and predict long-term
> business trends and advantages then it is to predict what is going
> to happen over the next few months or weeks." is comical.
>
> Prove it.
>
> This is just more Wall Street marketing (aka give me your money to
> invest for you.)

2009 Oct 18 06:01 PM

[mbkelly75]

Stocks with RISING dividends have done quite well - even in this last 20 year period. In point of fact, they have been shown (by Ned Davis Research) to beat the S&P 500 by an average of 2.7% annually and this holds true for even 10 year periods so you do not have to hold for a number of decades to get the benefit. They are also one of the best ways to stay ahead of inflation and have done so with consistency.
On the other hand, even though I have had a couple of stocks for 50+ years - Cramer made a good point with what he termed buy-and-homework as opposed to buy-and-hold. I was doing that LONG before I heard of him and will continue to do so. Have you figured the percentage return of a dividend from a stock with a zero cost/basis??????? It is VERY nice no matter how you figure it.
David Knapp has an excellent article right here about his 10X10 Table: www.dividendgrowthinve...

2009 Oct 18 08:17 PM

[jaderdavila]

the only time i care
is the time it takes to mature, to complete the cycle
and then i sell
exemple:
staroup jeans works with profit
it asked money to build a new factory
i gave the money
it took one year to build
one more year starting operations
and one more year to fine tune the operation
in three years it showed in the accounting that the company
have doubled its size
the analysts advised their clients to buy and i sold
2-another item i pay attention
is if the persons are the same
the people that already did one thing right
will do the second thing right
if a key person left the company
the company turns into another thing
the chemistry that worked for one success
if it changes there will be no second success

2009 Oct 19 04:47 PM

[Benny D.]

I LOVE dividends, I buy Closed end mutual funds (including "buy - write" funds which use covered call income), I buy when stocks are falling. When stocks rise significantly (approx 20%) I take some profit and place the proceeds in a Short term bond fund which I hold forever.

this way I receive dividens, intrest and capital appreciation in any type of market. I typically hold funds of large cap dividend players as well as funds that hold a spectrum of bonds investment grade & junk. I am 36 years old now maybe when i am say 60 I will sell.

Disclosure - Cohen & Steers Global income Builder (INB) : Buy write strategy, selling at discout, Stocks of companies with sales abroad and at home.
Vanguard ST Investment grade (VFSTX) And Vanguard High yield (VWEHX)

BD

2009 Oct 20 12:09 PM