On the first day of our journey, Monday, we learned the three rules of investing:

1. You aren’t allowed to change your investment decision time-frame.

2. You’re not allowed to predict the future.

3. You can’t have your cake and eat it too.

Yesterday, we looked at market timing. The major conclusion is that market timing can be a very good long-term approach but almost always a very bad short-term investment strategy.

Today, we’re going to look at buy and hold.

Believe it or not, there can be a number of variations to this approach and there are many ways investors use the buy and hold strategy.  Some people buy and hold funds, others buy and hold stocks and others buy and hold bonds.

For our purposes, we’ve going to look at the strategy of buying and holding the S&P 500 index because its probably one of the best ways to track overall market performance. Here’s more on the S&P 500 from Wikipedia:

The S&P 500 is a value weighted index published since 1957 of the prices of 500 large cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock markets, the New York Stock Exchange and NASDAQ. Almost all of the stocks included in the index are among the 500 American stocks with the largest market capitalizations.

There are three steps to implement the buy and hold strategy:

1.  Invest in a S&P 500 index fund or an S&P 500 exchange traded fund.

2. Do not sell it.

3. Repeat step 2.

It doesn’t get much simpler than that…right?  So how do you explain this?

This statistic is very important to you.  This shows that while funds (in this case a NASDAQ index fund) earned over 9% over a 5-year period, people who invested in the fund earned only 4.3% How can this be so?

You can’t blame that failure on the strategy.  You have to look at the investor.

The reason most investors fail to earn even half of what their investments earn is because they allow their “gut feelings” to take over . They abandon their strategy – usually at the worst time.

Most professionals tell investors that they should stop that behavior.  That’s like telling me to stop eating brownies when my wife has just pulled a tray of those bad boys out of the oven. ( If I’m in the same zip code as those brownies, they won’t see the light of day – even though I know better.)

Likewise, investors know that if they simply hold on to their investments, over time, they’ll do better than if they try to get in and out based on their emotional comfort level. They know this, yet they continue to exhibit detrimental behavior.  Here’s why:

This chart shows you the annual returns in the second column and the long-term average returns in the last column.  If, for example, you started investing in 1968, you still averaged 9.61% through 2008.  But that wouldn’t be any comfort….would it? You lost 39.3% in 2008 and that’s enough to worry anybody.  As a result, many investors – even people who thought of themselves as long-term investors – bailed out.

Buy and hold doesn’t work when we shift our time-frame and people often do shift their time frame as the pain increases.  This is a violation of rule #1.  Like market timing, buy and hold is a long-term approach.  When you shift to a short-term view, your goose is cooked.  You’ll do the hokey-pokey with your investments.  “You put your money in, you put your money out, you put your money in and you shake it all about…..”  You’ll lose a lot of money this way.

If you want to make better investment choices think about seat belts and penicillin.

They both kill people.  Did you know that?  1 in 10,000 people die in car crashes BECAUSE they wore a seat belt.  Does that mean seat belts are dangerous?

400 people die every year because they took penicillin. So, does that mean we should destroy all the pharmacies? Of course it doesn’t.

If we look back over the last 72 years, the S&P 500 has gone up in value 95% of the time.  So, if you have a 10 year time-frame, it is prudent to invest in the S&P.

But it does fail 5% of the time.  That’s what happened over the last 10 year in fact.  The S&P 500 index declined a bit more than 2% over that period.

That’s unsettling of course.  But it goes with the territory. Does that mean that in 1999 when you decided to invest in the S&P 500 that it was a bad decision?  No.  You made the best decision you could at the time with the information available.

Buy and hold is another example of a great strategy that can help you achieve your long-term goals.  It is not perfect.  It can and does fail. But it can still be an excellent approach to investing.  You have to consider the alternatives.

Tomorrow we’ll have a look see at asset allocation and why some experts think its the best strategy available while others think it is the worst.  You be the judge tomorrow.

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