Why Is Buy-And-Hold So Hard To Follow?

by: Henry Ma, CFA

Summary

Average equity mutual fund investor returns lagged buy-and-hold strategy by a large margin.

Buy-and-hold is hard to follow because of its inherent flaw and our own human nature such as fight-or-flight response.

A well-designed dynamic asset allocation with emphasis on limiting downsides will serve investors better.

According to the 2014 release of Dalbar's Quantitative Analysis of Investor Behavior (QAIB), the average equity mutual fund investor lagged S&P 500 Index by a large margin over various investment horizons (see Table 1). Over last 20 years, investors would have earned 4.2% more annually if they had just bought a index fund and held it ("buy-and-hold"). The most important reason for the under-performance was that the average investor had a tendency to buy stocks after markets had risen, then sell stocks when markets had fallen. QAIB was first published in 1984. Since then, a lot of investment education has taken place with the attempt to make investors' decisions more rational. However, the gaps between the investor returns and market returns have not improved at all.

Table 1: Investor Returns vs. Market Returns (as of Dec. 2013)

 

Average Equity Mutual Fund Investor Return (%)

S&P 500 Index (%)

Gap (%)

20 Year

5.02

9.22

4.20

10 Year

5.88

7.40

1.52

5 Year

15.21

17.94

2.73

3 Year

10.87

16.18

5.31

1 Year

25.54

32.41

6.87

Why is a simply strategy like buy-and-hold so hard to follow? In my opinion, the reasons can be found in both the inherent difficulty of the strategy and our own human nature.

(1) Uncertainties on the severity of market downturn and timing of market recovery. Buy-and-hold could be a reasonable long-term investment strategy since the equity market does have a long-term uptrend despite the short-term volatility. However, once in a while, the markets may experience major downturns. The inherent difficulty of following buy-and-bold is the uncertainties on how deep the losses will be and how long it will take to recover during those downturns. The downturns in the US history were normally steep and it took a long time to recover (see Table 2). Investors normally have limited investment horizons to meet their investment goals such as retirement or college tuition, etc. Given those uncertainties, investors tended to sell their stocks close to and at the bottom of the markets after incurring significant losses.

Table 2: Major Market Downturns

Begin Date

End Date

Event

Drawdown

Time to Recover

Aug-29

Jun-32

Great Depression

-86%

22 years

Dec-72

Sep-74

Oil Crisis

-46%

6 years

Mar-00

Feb-03

Tech Bubble

-44%

5 years

Oct-07

Feb-09

Housing Bubble

-53%

4 years

(2) Fight or flight response. According to physiologists, when they face perceived harmful event, attack or threat to survival, human beings normally react with fight or flight. In the investment world, when drawdowns or losses occur, investors may choose to hold on to the stocks at beginning (to fight). Then, as the losses deepen, investors would give up and sell the stocks (to flight). This physiological response as part of human nature works against any passive strategies like buy-and-hold.

In reality, buy-and-hold is not a good or even a feasible solution for average investors. When an investor suffers a significant loss, it will hard for any advisor to convince him/her to hold on to the losing positions. A well-designed dynamic (tactical) asset allocation strategy with an emphasis on limiting downside risks will serve investors better. With that, investors will have the confidence to stay in the course for the long haul without triggering irrational fight-or-flight response during market downturns.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

About this article:

Expand
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here