Previously, we looked at a few commonly perceived negatives on the buy and hold investment strategy.
Some of the minor complaints.
Today we will review more legitimate concerns.
Buy and Hold May Not Provide Maximum Possible Returns
A buy and hold strategy is essentially as it states; you acquire an asset and hold it throughout the investment horizon.
Investment theory indicates that over time, on average, appreciating assets (such as equities) will increase in value. Granted, it may be a long time, but historically this has held true.
However, over the short and medium periods, there may be large price fluctuations in an asset. The greater an asset’s risk (aka volatility), the greater the potential price swings.
If an investor can properly time the peaks and valleys of short or intermediate price fluctuations, the investor can sell high, then repurchase the same asset when it falls. This ensures the same position at the end of the investment time frame, but by selling and buying back the investor can profit on price fluctuations.
In short, the belief is that active management can outperform passive investing.
I would say that this is a legitimate issue for a buy and hold strategy.
However, I would also say that it is questionable if active can outperform passive over the long term.
Buy and Hold Does Not Protect in Down Markets
Markets, and the assets within a market, go through down cycles. Depending on the length of time, this may be called a crash, market correction, or possibly a bear market.
A buy and hold strategy sees investors sit tight during market descents. With some bear markets, this can wipe out previous accumulated gains and/or create portfolio losses.
Smart investors shift their assets in down markets into defensive positions or alternative asset classes that protect their capital.
Again, active management can protect portfolios during down cycles. However, as linked above, the ability of active managers to correctly time market corrections is (surprisingly) poor.
As a current example, google the amount of experts who predicted U.S. interest rates would significantly rise (over the last 3-5 years). Yet interest rates have remained relatively stable versus predictions. Had you not listened to the “experts” and remained in long duration bonds (as opposed to shortening durations in anticipation of rate hikes), you would have been better off.
Or consider how the “experts” reacted to the 2016 Donald Trump election victory.
“It really does now look like President Donald J. Trump, and markets are plunging. When might we expect them to recover? A first-pass answer is never… So we are very probably looking at a global recession, with no end in sight.” Paul Krugman of the New York Times the day after the election.
“If Trump wins we should expect a big markdown in expected future earnings for a wide range of stocks — and a likely crash in the broader market (if Trump becomes president).” Eric Zitzewitz, former chief economist at the IMF, November 2016.
“Trump would likely cause the stock market to crash and plunge the world into recession.” Simon Johnson, MIT economics professor, in The New York Times, November 2016.
“Citigroup: A Trump Victory in November Could Cause a Global Recession”, Bloomberg Financial News, August 2016.
Pretty impressive group. Smart! And more geniuses at the link.
Yet on November 7, 2016, the night before the 2016 U.S. election, the Dow Jones Industrial Average (“Dow”) closed at 18259.60 and the S&P500 (“S&P”) at 2131.52. One year later, the Dow closed at 23557.23 and the S&P at 2590.64. Not including investor gains from dividend distributions, a price gain in the Dow of 29% and S&P of 21.5%.
On July 5, 2019, the Dow closed at 26922.12 and the S&P at 2990.41. Again, not including distributions, the price increase since the election has been 47.4% in the Dow and 40.3% in the S&P.
How was following the “experts” as a strategy? Imagine if you moved everything into cash. Or, even worse, decided to short the markets in anticipation of a crash and/or global recession.
As someone who reads financial and business articles on a daily basis, this is the norm, not the exception with experts. The personal biases, political agendas, “herd mentality”, populist takes, or the extreme opinions to generate clicks, etc. All contribute to poor recommendations.
So yes, the lack of down market protection is another legitimate concern for buy and hold. But the bigger issue is, will you be able to correctly predict major market movements?
Buy and Hold Only Works if You Are Immortal
If you adhere to modern portfolio theory, you believe that in the long run, appreciating assets increase in value based on certain factors. And, as we saw in my second link above, this has held true for the last 100 years in all major asset classes.
But that may require an extremely long holding period. One not all investors can maintain.
Many investors do not seriously begin to invest until they are in their early 40s. If they need to liquidate at 65, 20 years may not be a long enough time frame. Had you invested in the Dow Jones Industrial Average at its peak in 1929, it would have taken 25 years for the Average to recover after its losses in the early 1930s.
Additionally, almost all investors have financial objectives covering different time periods. If you are 30, you may have a 35-40 year time horizon until retirement needs arise. You can take a longer term, higher risk perspective. But you may also want to buy a home in 3 years and finance your child’s education in 15. For short and medium term time horizons, you need to factor in other variables for your portfolio and strategies.
One’s investment time frame is relevant to the potential success of a buy and hold strategy.
These three concerns are common when you read articles on buy and hold investing.
These concerns suggest that active management is better than passive. But if active tends to not outperform passive, how can you protect your portfolio in volatile or bear markets?
We will consider this question in my next post.
