FINANCIAL LIFE | FALL 2010 EFFECT

Is Buy and Hold Still Relevant?

by John Gustavson

You’ve heard the storyline many times: over the long term, stocks outperform all other asset classes, including bonds, bank certificates of deposit (CDs), and real estate. Since 1927, U.S. stocks have returned (with dividends reinvested) about 10 percent per year, according to information from Bloomberg and Ibbotson Associates. The only problem with this statistic is it represents an average.

The truth of the matter is the stock market rarely gives investors an average year. It is a risky place to invest with volatile and inconsistent returns. Of course, anyone paying attention over the last few years can attest to these statements.

Dow Jones Industrial Average: Dispersion of Annual Stock Market
Returns	Percent of Years (1901 to 2009)
< -10%	21%
-10% to 10%	31%
> 10%	48%

Source: Crestmont Research 

In it for the long haul

American economist and investor Benjamin Graham is often cited for this metaphor: in the short run, the market is a voting machine; in the long run, it’s a weighing machine. I think he meant that investor emotions will rule in the short term, much like an election. However, in the long term, the stock market is a scale that will weigh corporate earnings and change correspondingly. In fact, there is a very strong correlation to the long-run growth trend of corporate earnings and the stock market trend. Given this knowledge, common wisdom is to invest for the long haul. There will be bear markets, but the economy and stock market have always come back. Is it best to stay fully invested (i.e., buy and hold) according to your risk tolerance and ride it out as popular wisdom suggests? It is not a loss until you sell, right?

The big come back

Sometimes the wait for the stock market to “come back” can be a long one. People who bought stocks in the late 1920s had to wait a couple decades to get their money back. Of course, that was a different time, and we now live in a society with safety nets (social security, unemployment insurance, government guarantee of bank deposits, regulatory controls, etc.). However, here’s a more recent example: people investing in the Dow Jones Industrial Average in 1966 had to wait until 1982 until their investments began to appreciate. Further, the S&P 500 is currently below its value reached in 2000, according to Bloomberg. So, we have to be careful with how we use the term “long run” because we are all dead in the long run too, as British economist John Maynard Keynes once said.

As investors, we always need to be aware of our investing time frame (retirement accumulation, house purchase, college funding, etc.) and understand that the stock market is volatile and may not yield the expected results, like the two time periods above. This is where hedging your bets with multiple asset classes may help reduce the risk of a funding shortfall.

Diversify and rebalance your portfolio

Stocks certainly play a role in creating wealth over time and should be represented as part of a diversified, multi-asset class portfolio, including bonds, real estate, emerging market stocks/bonds, and commodities. In fact, a portfolio holding a combination of these over the last 10 years, with rebalancing, did remarkably better than the S&P 500 alone, according to data from Research Affiliates, LLC. Buy and hold requires discipline and active rebalancing of your portfolio. So, when stocks are below your stated long-term allocation, you buy more and sell a portion of your best performer (e.g., bonds) and vice versa. In theory, this works well and should enhance returns, but in practice it is an entirely different deal, as emotions tend to get in the way.

For those of you who have bought and held a diversified portfolio, including multiple asset classes, and rebalanced (bought more stocks during the declines), you are probably in the minority and on your way to wealth creation. Just don’t let buy and hold turn into buy and forget.

 

One should not rely on this information for the primary basis of investment, tax or financial planning. General market information does not take into account such factors as an individual’s goals, objectives, risk tolerance, tax situation, age, or time frame. We believe the information obtained from third-party sources to be reliable, but neither LarsonAllen Financial, LLC nor its affiliates guarantee its accuracy, timeliness, or completeness. The views, opinions, and estimates herein are subject to change without notice at any time in reaction to shifting market conditions. Tax laws change and investments in the stock market entail risk and potential loss of principal. Past performance is no guarantee of future results. Note that one cannot invest directly into an index, and diversification cannot assure a profit or guarantee against a loss. This material may not be republished in any format without prior consent.