In 1999, global stock markets were at the peak of an 18-year secular bull market. Buy-and-hold had become a mantra. That's no big surprise. At that time, there was no doubt that a person who had bought and held U.S. stocks (NYSEARCA: SPY) over a long period would have made more money than in almost any other investment. But that belief was neither rocket science nor sound investment advice. It was merely a simple observation. Yet books, articles, and investment seminars, by the truckload, were produced that expounded on the benefits of buy-and-hold.
For many people the validity of the buy-and-hold myth has shriveled, along with the values of their stock portfolios, throughout the secular bear market that began in 2000. For many others though, the buy-and-hold approach continues to be a rallying cry and is continually touted as being a virtue and the ultimate strategy. However, buy-and-hold is not a viable strategy at all; it is merely a way to rationalize losses.
Let's first review the historical results upon which this myth is based (using data provided by Robert J. Shiller, author of the bestselling book, Irrational Exuberance [i]).
Returns of Buy-and-Hold Strategy
U.S. Stocks Since 1900 [ii]
Since the start of 1900, U.S. equities produced a real average annualized return of 1.82% if dividends were spent, rather than reinvested, and a 6.27% real annualized return with dividends reinvested. The "real" return adjusts the performance for the negative effects of inflation, which reduced the returns by more than 3% per year on average. If we were to look at the "nominal" return, the amount stocks earned before adjusting for inflation, the returns jump to 4.92% if dividends were spent and 9.51% with dividends reinvested.
We are showing the returns both with and without the reinvestment of dividends to stress the importance of reinvesting dividends. For various reasons, such as the fact that people are taxed on dividends and want to have the money available to pay taxes, many people do not reinvest their dividends. As the data in the table above show, over time, this neglect will cost them the vast majority of their cumulative profits.
On the surface, the nominal return, with dividends reinvested, seems to fit the definition of "healthy." Someone placing $100 in U.S. equities at the start of 1900 and holding tight for the next 111 years, reinvesting all dividends, would see their portfolio grow to a stunning $2,383,810 by the end of 2010. It clearly demonstrates the power of compounding, which Albert Einstein said was one of the greatest human creations he had known.
Even after adjusting for inflation, the ending value of this portfolio is $85,598. This is still an outstanding return. Taxes would reduce these returns further but are not included in these calculations due to their ever-changing nature and varying impact on each person.
What is obvious from the data, however, is that the majority of the real returns did not come from stock price appreciation, but from dividends. If, rather than reinvesting the dividends, a person spent them instead, the real value of the portfolio at the end of 2010 - 111 years later - would be only $744.
The chart below illustrates the real (inflation-adjusted) growth in an initial $100 placed into a basket of U.S. stock at the start of 1900, assuming dividends are spent and not reinvested. This will undoubtedly concern people who have been told, as long as they've been alive, that stocks work best over the long-run. The most interesting observation here is that it took until 1950 before the value of the initial $100 exceeded and stayed above that $100 value.
Growth of $100 Placed into U.S. Stocks in 1990
Real Returns - Without Dividends
This means that for more than 50 years any person who placed $100 into a broad basket of U.S. stocks [such as (NYSEARCA: IBM), (NYSEARCA: KO), (NYSEARCA: CAT), (NYSEARCA: JPM)] and who did not reinvest his or her dividends, would have suffered a loss, allowing for inflation. This really does give new meaning to the term "long run."
However, perhaps even more is the fact that all of the real stock market returns earned over the past 111 years can be attributed to just an 18 year period - the great bull market that began in August 1982 and ended in August 2000. Without those 18 years the real, inflation-adjusted return of stocks, without reinvesting dividends, was negative!
This highlights the greatest risk of the buy-and-hold strategy, which is that stock market returns are extremely "lumpy".
Buy-and-hold is NOT a sound investment strategy.
So, is there a better alternative to this buy-and-hold strategy? The answer is "ABSOLUTELY". Please visit www.jackassinvesting.com to learn how to create a portfolio that earns greater returns with less risk than this typical buy-and-hold approach.
This article is excerpted from Myth #2 of "Jackass Investing: Don't do it. Profit from it." by Michael Dever.
About the Authors:
Michael Dever is the CEO and Director of Research for Brandywine Asset Management, an investment firm he founded in 1982. He is also the author of "Jackass Investing: Don't do it. Profit from it.", which is the Amazon Kindle #1 best-seller in the mutual fund and futures categories. John Uebler is a Research Associate for Brandywine Asset Management. Please visit www.brandywine.com and www.jackassinvesting.com.
[i] Robert J. Shiller, Irrational Exuberance (Princeton: Princeton University Press, 2000, 2005, updated). Data used in Shiller book and for S&P 500 Total Return performance available at: econ.yale.edu/~shiller/data/ie_data.xls. Retrieved February 14, 2011.
[ii] Shiller, "Irrational Exuberance."