The following post was first published April 22, 2009 – almost exactly the day when the market hit a bottom after the 2008 crash and started a long and profitable recovery. This article is part of a series that discussed a variety of investment strategies. The main lesson is as valuable today as it was then.
On the first day of our discussion about investment strategies (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. That may sound weird but it’s true. If you use tools to guide you both in and out of the market – even if you only make one or two calls a year – you won’t get every call right. You have to evaluate your model over a very long period of time in order to determine if the benefits outweigh the costs.
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 for building their wealth. 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 it’s 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 with this index:
1. Invest in an S&P 500 index fund or an S&P 500 exchange traded fund. (Here’s a nice discussion of ETFs vs Mutual funds for those interested.)
2. Do not sell it.
3. Repeat step 2.
It doesn’t get much simpler than that. And you’d expect investors who buy and hold to capture most of the gain (or loss) of the overall market. Makes sense…right? So how do you explain this?
This shows that if you bought and held the fund (in this case a NASDAQ index fund) you would have earned over 9% over a five-year period. But it also shows that the average person who invested in the fund earned only 4.3% How can this be so? You can’t blame that failure on the strategy. If you bought and held this index you would have earned more than twice what the average investor actually made. 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.
This chart shows you the year-by-year returns in the second column and the long-term average returns in the last column. If, for example, you started investing in 1968, you earned a 9.61% through 2008 on average – which is great. But look at the YTD 2008? You lost 39.3%. 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 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 if you look at each 10-year period over those years. 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 years 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 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. It also often ignores risks and unfolding opportunities. 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.