3 Reasons Buy And Hold Stock Investing Is The Single Best Way To Build Wealth

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Includes: DIA, QQQ, SPY
by: Dividend Sensei

Summary

There are lots of potential investing strategies one can pursue in an effort to build long-term wealth.

Market timing is one common approach that many investors try, but to their detriment.

Historical studies are very clear that market timing is the absolute worst thing most investors can do.

In contrast buying and holding quality stocks is the most powerful wealth building system ever discovered. And over time dividend growth stocks are the single best asset class you can own.

And if you are worried about bear markets and recessions, remember that these tend to be short lived and markets tend to recover to all time highs within 15 months. Good asset allocation is how you reduce your risks during market downturns and sleep well at night.

(Source: imgflip)

Note that due to reader requests I've decided to break up my weekly portfolio updates into three parts: commentary, economic update, portfolio summary/ stats/ watch lists. This is to avoid excessively long articles and maximize the utility to my readers.

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It's human nature to want to avoid painful short-term stock market (SPY) (DIA) (QQQ) losses. In fact, studies have shown that in general it hurts twice as much to lose a dollar as gain a dollar. This explains why market timing continues to be something of great interest to many investors.

However numerous historical market studies make it very clear that market timing is a fool's errand for most investors, and nothing more than a siren's song that can lead you to your financial doom. Let's take a look at the three reasons that buy and hold stock investing is the single best way for you to build your wealth over time and achieve your financial dreams.

Stocks Are The Best Performing Asset Class In History

When it comes to wealth building over time nothing compares to stocks. Since 1871 the market has generated 9.2% annualized total returns which would have turned $1 into $389,591. Adjusting for inflation the stock market has historically returned 7% CAGR total returns turning resulting in a 19,756 fold increase in your wealth over the past 146 years.

(Source: Credit Suisse)

Compare that to bonds and cash equivalents (short-term Treasury bills) and you can see that either on an absolute or inflation adjusted basis stocks are the best way to build long-term wealth. This is why Warren Buffett, the greatest investor in history (26% CAGR total returns over 50 years), recommends passive index funds for most investors. Simply put, long-term ownership of stocks is as close to a "sure thing" as you can find in finance.

Of course for those of us looking to beat the market and or live off passive income dividend stocks are a way to supercharge stocks' incredible wealth compounding effects.

That's because over time high-yield dividend growth stocks have been the best performing equity type, and thus the single best asset class in history. For example, between 1928 and 2013 the 40% highest yielding stocks in the S&P 500 generated 11.25% CAGR total returns compared to 8.3% for non dividend stocks. Meanwhile thanks to 32% lower volatility their risk-adjusted returns were 143% better. Or to put another way, high-yield dividend stocks are a great way to earn market beating returns with lower volatility, which helps you sleep well at night during unavoidable downturns.

Stock Market Outperformance By Yield Range

What's the best type of dividend stock to own? Well between 1969 and 2011 stocks yielding 3% to 6% offered the best outperformance to the S&P 500, while also offering the best risk-adjusted returns (information ratio in the above chart). Stocks yielding less than 3% put up slightly lower but still impressive outperformance, both on a risk adjusted and absolute basis. Only the absolute highest yielding stocks failed to outperform on a risk adjusted basis, likely owing to the fact that a stock that yields over 9% is generally lower quality and potentially distressed.

But the point is that stocks in general, and dividend growth stocks in particular, have historically been the best way for regular people to grow their wealth over time. However, it is true that as "risk assets" stocks are also more volatile than other assets like cash equivalents or bonds. This means they do tend to fall more during recessions and bear markets. But even that highest volatility doesn't mean you should avoid owning them.

Recessions And Bear Markets Are Short Lived And Typically Don't Take Long To Recover From

The Great Recession was the worst economic downturn since World War II and so understandably many investors fear that when the next recession hits stocks are likely to plunge. However, it's important to remember that the Financial Crisis was an exception and not a rule. The freezing up of credit markets meant that the recession was much longer and deeper than most since WWII. For example, between 2008 and 2009 GDP fell 5.1% over a 18 month period. In contrast, excluding the Great Recession the average recession since 1945 has last 10.4 months and resulted in GDP declining just 2.0%.

And since Basel 3 global banking accords have greatly increased the capitalization of major financial institutions, it's unlike that the next recession will be triggered by another financial crisis that induces a long and deep recession. In fact, annual stress tests of major systematically important financial institutions or SIFIs simulate a far more severe global recession than 2008-2009. Yet almost without exception major banks are passing these worst case scenario tests indicating that even if a major recession strikes the world's financial structure will likely survive without the need for bailouts. Ultimately this means that the next recession, whenever it comes, is likely to be a mild one lasting around one year (or less) and with GDP falling 1% to 2%.

But what about stocks? The 2000-2002 tech crash saw the market nearly cut in half despite the mildest recession in US history. But here too there is little reason for alarm.

(Source: First Trust)

Even if you include the Great Depression, in which the Federal Reserve stupidly contracted the money supply during the crisis, the average duration of a bear market was 17 months and the average peak drawdown was 41%. Given that the Fed's policies towards financial crises is now 180 degrees opposite of that pursued during the Depression, a repeat of that worst case scenario is unlikely. Thus it's more useful to look at bear markets since WWII.

(Source: Moon Capital)

During the typical bear market it takes the S&P 500 16.2 months to fall from its last all time high to its eventual bottom, which is on average 34% lower. The median peak drop is 30%. This large downside volatility is the primary reason that so many investors want to market time, with hopes of selling stocks near the top and theoretically buying back in after the crash is over. Those near retirement (or already retired) are especially worried about the need to potentially fund expenses by selling stocks during such a sharp downturn, especially if they are following something like the 4% rule.

But here's the most important thing to realize about bear markets. While they are painful, they are usually short lived and the market usually recovers quickly to all time highs.

(Source: Moon Capital)

The bear market recovery period is how long it takes stocks to recover their all time highs after bottoming. Since WWII the median recovery period has been 15 months with the longest being 69 months. The Financial Crisis was the second longest with stocks taking about 5.5 years to fully recover from the second largest losses in market history (behind the Great Depression's 90% plunge).

Similarly in 2000 the third largest crash in history took four and a half years to fully recover from. This shows that the larger the crash the longer stocks are likely to take to get back to all time highs. But doesn't that mean that market timing is potentially a smart idea, especially for retirees or those nearing retirement? Actually no, that's not what most financial advisors recommend at all.

Model Retirement Portfolios

(Source: Charles Schwab)

Rather the smart thing to do is to shift one's asset allocation (the mix of cash/bonds/stocks) in such a way as to continue benefiting from the market's superior wealth building power while minimizing downside risk during a bear market. In fact, Charles Schwab (SCHW) recommends that even 65 year old retirees still maintain 60% exposure to stocks, and don't use market timing. And for even highly conservative portfolios such owned by risk averse retirees in their 80's a 20% exposure to stocks is recommended. How can that be a good idea? Because the 10% to 30% cash position allows retirees to fund their living costs without having to sell stocks at depressed prices. Meanwhile bonds and stock dividends slow the rate at which you have to draw on your cash reserves. This buys you even more time to wait for the stock market to recover.

Or to put another way, asset allocation, not market timing is what most advisors recommend investors use. The reason is that historical studies indicate that market timing doesn't work. In fact, it's the single worst thing you can do with your portfolio.

Market Timing Just DOESN'T WORK For Most People

Market timing is theoretically a great idea in which you sell all your stocks at near the market top, and then get back in at the bottom, just in time to benefit from the next bull market. However, in reality it's a fool's errand that even billion dollar hedge funds and asset managers struggle to do well. How about regular investors? Well according to JPMorgan (JPM) Asset Management over the past 20 years the average investor's attempts to time market tops and bottoms have resulted in abysmal returns of just 2.6% CAGR. After inflation that comes to just 0.5% over about half an investing lifetime.

Why is market timing so difficult as to border on the impossible? Well for one thing because stocks are extremely volatile and in the short-term driven primarily by unpredictable and often irrational investor sentiment. But the biggest reason is that most of the market's long-term gains are derived from just a handful of its best days.

(Source: Morningstar: Fundamentals For Investors 2018 Report)

For example, over the past 20 years buying and holding the S&P 500 would have resulted in a 7.2% annualized total return. However, missing just the 10 best market days would have cut that long-term return in half. Missing just 50 of the best days (less than 1% of market's best days) would have resulted in -4.5% annualized total returns. For context a -4.5% CAGR total return over 20 years is a 60% decline in your portfolio, as opposed to a 302% gain which buying and holding the S&P 500 would have delivered. And that's despite the two biggest crashes since the Great Depression.

Worse still? Generally the market's biggest gains come within two weeks of its biggest daily losses. For example during the financial crisis the stock market had days that it went up 6% to 12%. That was in between daily drops of between 5% and 8%. This means that if you want to actually time the market profitably, you can't just sell out near a top and avoid the entire bear market. You'd have to actively trade in and out of the market during times of peak volatility. In other words, you'd have to become a master day trader, accurately forecasting what days the market is going to plunge and what days it's going to soar.

But who cares about market history? The future is uncertain which is why all financial marketing comes with the warning that "past performance is not guarantee of future results." While this is certainly true in the words of Mark Twain "history doesn't repeat itself, but it often rhymes." This means that investing to achieve long-term financial goals is about playing the probabilities and going with what is most likely to work.

This is why investing buy and hold investing in stocks is the best approach for most people. Because it offers the greatest probability of success.

(Source: Morningstar: Fundamentals For Investors 2018 Report)

For example, in any given year the stock market has a 74% chance of going up. Over a five year period that rises to 86%. And since 1928, which means including the Great Depression, the stock market has never failed to return positive results over a 15 year or longer period. Think about that for a moment. Even if you had invested at the 1929 market peak, and factoring in the market's 90% plunge during the Depression, by 1945 you would still have generated positive total returns. And that's assuming you never took advantage of the market's huge crash to buy quality stocks at fire sale prices. That would have drastically lowered your cost basis and resulted in a much faster recovery period and higher long-term total returns.

Bottom Line: Time In The Market Is Far More Important Than Timing The Market

While it's human nature to want to avoid short-term capital losses we have to remember that recessions and bear markets are natural and unavoidable parts of the economic and market cycle. And since these tend to be unpredictable the best strategy for most investors is a buy and hold approach to owning stocks. That either via an index fund, or through quality individual holdings such as high-yield dividend growth stocks which are the best returning asset class in history.

While a lucky few master traders might be able to jump in and out during times of peak volatility, history is very clear that for the average investor market timing is a disastrous approach. One that will end up costing you a fortune over the long-term, and could make it impossible to achieve your long-term financial dreams.

This is why it's important to keep investing in context, which means knowing economic/market history. The economy and stock market are rising the vast majority of the time. And given that downturns tend to be short and quickly recovered from, this is why a buy and hold approach to stocks is the easiest and least risky road to riches for most people.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.