“Buy and Hold” is Dead. You Must Pay Attention to Your Investments.

Posted on April 19th, 2009 by admin in Quant

A key stock market investment strategy recommended by countless brokerage firms to their customers is called “buy and hold”. This strategy cannot be recommended anymore.

“Buy and hold” means it doesn’t much matter when you buy stocks, just pick good firms and hold for a long time and expect a rate of return superior to the bond market, with a bit more risk. For many years this approach seemed to work. But in 2008 this approach started to fail without scrutiny.

This was a valid strategy as long as you entered the market during the long, historical bull phase, and bought mostly firms that would survive, and lived long enough (“blue chips”). The long term (secular) trend clearly was up, if for no other reason than the stocks that get traded must profitably survive to be counted!

This chart offers a dramatic way to make the point that stocks trend up, but that you may suffer deeply as you wait. Consider this graph published by dshort.com:

2009-04-19_sp_composite_1871-2009

You can see 138 years of upward trending stock prices (as measured by S&P Composite Index). It also shows several deep bear markets along the way. You could have entered the market and gotten a multi-year bull market or a multi-year bear market, and you couldn’t know. It also shows how you can wait many years, over 20 in some cases, for positive ROI.  So the question is: how long does “buy and hold” require?

Before we deal with the question of “how long to wait”, let’s discuss what we must wait for. We need to wait, after major bear drawdowns, to have prices rise close to the previous peak. So, do the math and plot the results. The graph below plots the ROI (vertical axis) you need after a fractional price drop (horizontal axis) to return to the initial price. The graph says nothing about how long it takes. But to give you an idea, suppose your portfolio dropped 50%. Obviously, it needs to double to return to original value. If you can get ROI of 10%/year, it will take roughly 7 years to double.

ROI Required to Return to Original Asset Value After Loss

ROI Required to Return to Original Asset Value After Loss

The intervals during which the bear claws his way down can last longer than a major chunk of a human lifetime. The idea supporting “buy and hold” was that you really had a lot more than 20 years to wait comfortably for your reward. This detail was unstated.

Take a look at this chart, which plots the S&P500 Index for the 50 years ending 2 JAN 09:

S&P500: Prices for 50 years ending 31 DEC 08

S&P500: Prices for 50 years ending 2 JAN 09

Now ask yourself if you would have been happy to buy and hold over a 20 year investment horizon. It appears that 20 years suffices to wait out the many periods of large price drops, had you entered market since 1950. But what about a 10 year interval: would that be enough to wait passively? It depends on timing. Consider this chart, showing S&P500 Index for the 20 years ending 2 JAN 09:

S&P500 Index 20 years ending 2 JAN 09

S&P500 Index 20 years ending 2 JAN 09

Those 10 year intervals don’t look so easy to pick at this scale.

Finally, consider this analysis ( Forbes Magazine, 11-24-08: Laszlo Birinyi, “Uncharted Waters”). A major argument for long-term investing has always been that if you get out of the market you may miss the good days when the gains are made.  Assume you had invested $1 at start of bull market in 1966 and ignored dividends. If you missed the five best days of each year, investment now = $1.11. Yup, that looks like staying in was best.

However, if you missed the five worst days each year, your investment now = $2,696. So you would have been a genius just to be on the sidelines some of the time, especially the right time! By this analysis, choosing when to exit market can be quite prudent. Yes, you still must choose, but (roughly speaking) the only way to be reasonably sure of passively winning in the market is to be able to wait at least 20 years (based on these hindsight ideas).

Underlying all these hindsight statistics is a large economic truth. The history of stock markets in USA since 1870 or so is one of stunning GDP growth, beginning with the Industrial Revolution, through creation of railroad, electric power, shipping, telephone, steel, automobile, airline, electronics and computer industries. After WW2, the Baby Boomers populated the country and consumerism took off, and then the Internet “Changed Everything”. The Boomers are entering retirement now, and their kids are entering a depression, and also have to support the collapse of social security for current retirees. Can we really expect the same level of GDP and market growth to continue as they have historically? Maybe. But paying deep attention to your money seems far more prudent than hoping it all turns out OK in 20 years.

Leave a Reply

More News