Here’s Why You Might Want To Rethink Buy & Hold

November 28, 2017

Here’s Why You Might Want To Rethink Buy & Hold

  • A buy and hold investing strategy sounds appealing, you buy something, forget about it for 20 years, and wake up rich.
  • However, it’s highly unlikely that such a thing happens.
  • I’ll discuss the main issues and benefits of a buy and hold strategy.



Introduction

Buy and hold is one of the most famous investing strategies, made even more famous by Warren Buffett himself.

For Buffett, the idea behind buy and hold is that all you have to do is buy a wonderful business at a fair price and hold it forever. However, there are many flavors of the buy and hold strategy, and today, we’ll discuss how the strategy as a whole fits in the current environment.

Buy & Hold

The main premises behind a buy and hold strategy are: that stocks are the best investment vehicle out there, better than real estate, bonds, cash, or gold; that what you buy you should hold forever and let your stocks work for you; that over the very long term, a portfolio of well diversified stocks always leads to positive returns. All have held true on the NYSE for the last 90 years, but if you look at it from multiple perspectives, you would see that 90 years is a very short time span to be certain about an investing strategy and a lot can change.

Just as an example, here are the deflated returns from stocks in the period from 1851 to 1921 and 1931. The cumulative return is a negative 25% over 80 years.

Figure 1: U.S. Stocks from 1851-1931. Source: McQuarrie.

If something like this happens again over the next 80 years, all investors can expect from a buy and hold strategy now is a 1.85% return. As dividends have been a huge contributor to investing returns in the past, it’s important to mention that current dividends are at historical lows. Thus, don’t expect what happened in the past to replicate itself in the future.

Figure 2: S&P 500 dividend yield since 1871. Source: Multpl.

First Concern – Risk Is Neglected

So my main concern with a buy and hold strategy now is that those who apply such a strategy do the most dangerous thing to do when investing, they don’t look at risks. Given that the S&P 500 price to earnings ratio is 25, we can expect a return from stocks of around 4% for the long term if the economic situation remains as is and the monetary policy remains accommodative.

Figure 3: S&P 500 price to earnings ratio since 1871. Source: Multpl.



The problem is that those risks become bigger and bigger as stock prices climb and valuations inflate. And these risks aren’t just the risk of a market correction or crash, the risk of applying a buy and hold strategy now is that it could impact your financial wellbeing for the next few decades.

If the stock market gives negative returns over the next 20 years, those who just buy and hold will be very much shocked by the difference between their portfolio values and their expectations.

Buy and hold has definitely worked over the past 35 years, but that doesn’t prove it’s the best investing strategy. At this moment in time, the potential risk of 20 years of negative cumulative returns simply doesn’t justify the reward of a 4% long term return.

The same applies to individual stocks. It’s all about risk and reward when investing and not thinking about risk might temporarily lead to higher returns in a bull market but over the long term, will definitely lead to lower absolute performance.

Just one example of that is that value investing has beaten growth investing in 84 years of the past 90 years. Similarly, even the great Warren Buffett isn’t such a great buy and hold investor. Earlier this year, Berkshire sold all of its General Electric holdings. Similarly, Buffett also significantly lowered his IBM position this year, further confirming how investing is about risk and reward, not about long term buy and hold whatever stock at whatever price.

Second Concern – Buy & Hold Is Actually Dynamic

Many think that by buying an index fund like the S&P 500, they are applying a buy and hold strategy but that couldn’t be further from the truth.

The S&P 500 is a dynamic index and is constantly adjusted according to the constituents’ market capitalizations. In fact, only four companies that were in the top 10 of the S&P 500 back in 2007 are still in the top 10.

Figure 4: The S&P 500 constantly changes – thus there is a lot of buying and selling. Source: Morningstar.



So those buying the S&P 500 now are buying the most expensive companies and probably not the companies that will dominate the S&P 500 in 10 years, certainly not in 20 years.

Conclusion

Following a predefined strategy that worked for a period in the past is a very dangerous thing to do because it doesn’t take risks into consideration. Taking risk into consideration implies constant portfolio rebalancing around that risk.

On top of everything, the world is changing at an amazing speed and what’s working now might soon be obsolete. This makes buy and hold even more tricky in this environment.

My message today is to apply a risk reward strategy to your portfolio and not to leave your financial future in the hands of a buy and hold strategy that just sometimes worked in the past and is currently trending.

On individual stocks, a buy and hold strategy might work, but only as long as the stock you bought still fits all the criteria you bought it for in the first place.

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