Why 'Buy and Hold' is a Misnomer

“Wealth isn’t primarily determined by investment performance, but by investment behavior.” – Nick Murray

Dr. Andrew Lo, a finance professor at MIT, recently shared his thoughts on a long-term, buy and hold strategy to Chuck Jaffe of MarketWatch:

That might sound like good advice because on paper when you take a look at the S&P over the last 10, 20 or 30 years the performance looks pretty good the longer you go. The problem is that advice is just not realistic. You can’t expect an investor to live through 2008-2009 and be perfectly happy to see their investments decline by 50 percent.

It’s not credible to say to an investor, ‘Here’s a stock index fund, you ought to just keep your money in it and don’t worry about it and leave it there for 10 or 20 years,’ That’s like telling a teenager he or she ought to abstain; it might be reasonable advice in the long run, but in the short run it’s very difficult to follow.

The takeaway here is that, sure, long-term investing makes sense, but it’s just too hard to put into practice.

There are psychological issues that make it difficult to think and act for the long-term, but what other choice does the average investor have? Chase past performance? Time the market? Pick the best performing asset classes ahead of time? Trade more often?

Being disciplined means accepting short-term unhappiness for long-term results, regardless of how difficult it is.

Jaffe provided a good response as he himself is a long-term investor, but I think that some in the investment industry do try to portray taking a long-term stance as being too hard in an effort to sell complex products or unnecessary services.

With the broad U.S. stock market once again at or around all-time highs it’s worth noting that a true buy and hold strategy has never failed to work. Investor behavior has failed a buy and hold strategy.

In fact, a study from the Federal Reserve showed that a strategy that followed mutual fund flows (what investors actually did) underperformed a simple buy and hold strategy (what investors should have done) by up to 5% a year. Over 7 years the total performance difference was as high as 40%.

It also makes sense to define what a buy and hold strategy really is. No one starts out with a pile of money to make a single purchase and then holds on for dear life. Investors make contributions over time and eventually take distributions for spending purposes.

A more realistic interpretation is buy & hold…and then buy & hold and buy & hold some more. It’s not guaranteed to work in the future, but I can think of much worse strategies. Is it an easy approach? No. Like all investment approaches it can be feast or famine depending on where we are in a given cycle.

The problem is perspective more than anything. We all want to earn high returns without taking any risk. Charlie Munger has the counter-argument to Dr. Lo on how to think about stock market losses:

In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century, you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get…compared to the people who do have the temperament to be more philosophical about market fluctuations.

Large losses are an unfortunate reality of investing in the stock market, but also the reason that the returns can be so great over time. Buy and hold only works if you do both when markets crash. It’s much easier to buy and hold during a bull market.

Everyone knows you should buy low and sell high. There are really only two ways to buy low in the stock market: (1) buy when stocks fall in price or (2) have a really long time horizon to invest.

The framework of buy and hold is really only a starting point. From there, it can be buy and hold AND determine a reasonable asset allocation AND utilize broad diversification AND rebalance periodically to stay within a stated tolerance for risk AND stick with the plan for the long-term.

Every investment strategy is impossible in some sense. Each one has psychological barriers. Prussian General Carl von Clausewitz once said, “The greatest enemy of a good plan is the dream of a perfect plan.”

Buy and hold is a good plan for most investors (not all). It’s highly imperfect, but there are no perfect plans. Investors have to ask themselves if there really is a better route to increase the probability for long-term success.

UPDATE: See Caveats on the Long-Term for my thoughts on some feedback from this post.

Sources:
Buy-and-hold is impossible (MarketWatch)
The cost of chasing returns (Fed Bank of St. Louis)

Further Reading:
Learning From Vanguard Investors
What if you only invested at market peaks?

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