The Buy and Hold Apocalypse
Market Timing Is Bunk
Buy and Hold
Longtime skeptical readers will be wondering why I am focusing so much on how to measure market returns in making my case for why the "buy-and-hold approach" is far from dead. In my Technophrenia series, I wrote an article called "A Market of Stocks," arguing that the very concept of a "stock market" was an historical anachronism created by the tighter linkage between companies when the U.S. economy was less complex. One of the main reasons why people want to measure the performance of the "market" outside of its component stocks is to enable some form of market timing, a practice that has convincingly been debunked by most academic work in recent years.
Market timing is bunk? Yep. Consider, for instance, the returns on small company stocks between 1925 and 1992. If you had been invested in small company stocks over this period, your average annual return would have been 12.1%. If you sat out the single best month during that 67 year period, you would have only made 11.2% a year. If you missed out on the best five months, well, forget it... you would have only notched gains of 8.5%. Finally, if you had missed the best ten months -- something all sorts of market timers managed to do in 1995 -- you would have only retained 6.3% annual gains, almost half of what you could have made had you been fully invested. This data and other data like it has proved again and again the wisdom of buying and holding stocks.
Certainly people can trot out responses to this that look at the value of missing the worst days or the worst months. There is only one slight catch there -- you have to know when to take your money out. Anyone can guarantee that their money is in the market during its best days in order to nail the 10.5% average annual return in large company stocks and the 12.1% average annual returns in small company stocks. All they have to do is not try to time the market. To miss the worst days and not miss the best days you have to have perfect timing. And given that the returns for the best single day or month often occur right after those of the worst single day or month, perfect timing is really important. Two of the largest single-day gains occurred in 1987, right after the precipitous October 19th drop.
The case for owning quality stocks purchased at a discount to their value as a continuing enterprise is made by simply looking at the returns for the Dow Dividend Approach -- a wonderful proxy for the classic "buy and hold" stock, a foundation of Foolish investing and a mindlessly simple approach to duplicate. Even during terrible market conditions over the past thirty-five years, stocks that meet this criteria have at the very least performed at break-even levels over five-year long periods. The long-term evidence overwhelmingly suggests that looking for true value stocks when the economy gets dicey is not a bad way to fly -- look at the returns for Dow Dividend Approach between 1973 and 1974. Long-term total returns for the Dow Dividend Approach over periods of ten years or longer have been simply incredible.
The latest drop in the "market" has caused many to tear at their hair and question the continued validity of owning stocks for long periods of time, hypothesizing that what we are seeing is a "buy and hold" apocalypse. The "buy and hold approach no longer works," they cry. However, no one ever said that you can buy just anything at any price and hold it. The emphasis of the "buy and hold" methodology has always focused on established companies which currently dominate the financial landscape, the kind of stock that routinely appears on the Dow Jones Industrial Average or the S&P 500 Average.
Short-term speculation, investing on margin, investing fresh money into a loser so that it grows to absolutely dominate your portfolio returns -- this is not the "buy and hold" approach. Certainly there will be weeks, months and even years where your investment returns are negative. If you have not appropriately girded your portfolio for market drops with "buy and hold" stocks, the falls can be quite precipitous. No one disputes the long-term returns of stocks and no one can dispute the fact that the longer your investment time horizon, the more likely you are to have higher total returns over any other option, with fifteen- to twenty-year horizons virtually guaranteeing this. Concerns that there has been a "buy and hold" apocalypse exist independent of the truth.