The No. 1 Reason to Be a Buy-to-Hold Investor

Back in the early 1900s, Italian economist Vilfredo Pareto noticed that about 20% of the peapods in his garden offered up 80% of the peas. Fascinated by this, he wanted to see if the same rules applied to human endeavors.

When he did the research, he found in fact that 80% of the land in Italy was owned by 20% of the population. Though the actual ratios vary, the basic principal remains the same: A disproportionately small number of subjects usually account for a disproportionately large amount of results.

So why does this matter to long-term, buy-to-hold investors?
If we take Pareto's principal one step further, we can say that 20% of trading days should account for 80% of the market's returns. If you're a trader, navigating in and out of stocks on a daily basis, there's a good chance you might miss some of the big days that make up huge gains for the market. And because the market historically goes up -- not down -- there are usually more up days to miss than down days.

If those big days were evenly spread out, we would expect days where the market jumped by more than 2% to be spread out like this, where each line represents an occurrence of a 2% (or more) market jump.

Buy-to-hold investors would already hold an advantage over day traders if this were the case, as they would never miss out on one of these outsized gains.

But as author and professor Albert-Laszlo Barabasi points out, such occurrences are rarely random and evenly distributed. Instead, they occur in bursts. Take a look at how the distribution of such big market gains (the S&P 500 (INDEX: ^GSPC  ) ) have been spread out since March 9, 2009 -- the market bottom of the Great Recession.

Source: Fool.com, author notes.

As you can see, such big leaps usually occur in bursts. If you aren't invested in these bursts, then you've missed out on the wealth-making machine that is the stock market. As fellow Fool Morgan Housel likes to say, "History doesn't crawl; it leaps."

To really drive home the point, consider this: The S&P 500 has returned 93.7% since the market hit rock bottom during the Great Recession -- not including dividends. If you had missed the five days with the biggest gains since then, your returns would only be 51.7%. In other words, a mere 0.6% of trading days accounted for 45% of gains.

Of course, skeptics will look to the data and point out that, obviously, with the market hitting rock bottom, euro jitters dissipating, and the debt-ceiling can being kicked down the road, any idiot could have guessed there would be huge market gains.

Of course, they'd be right -- if we knew those things were coming. Few people could foresee the large market days before they came.  In reality, there's no way to tell when and where the next burst may occur. If someone tells you it's coming, ask them to be specific, then see if they're right.

That's why market timing just doesn't work, and investing as if you own the businesses you're buying does.

This isn't just a macro-issue
Just in case you read this thinking, "Who cares. I invest in individual companies, not the total market," consider the following five companies. I own all five of them, and they have performed very well in 2012.

If you take out the single day with the biggest gain, look at how the returns change. Click on the days with the biggest gains to find out what caused such gains.

Company

2012 Returns

Biggest Single Gain

Returns Without the Biggest Day

Apple 41% April 25 -- 8.9% 28%
Whole Foods (Nasdaq: WFM  ) 40% May 3 -- 7.6% 30%
Stratasys (Nasdaq: SSYS  ) 48% April 19 -- 16.2% 32% 
Solazyme (Nasdaq: SZYM  ) 11% April 3 -- 12% 1%
IPG Photonics (Nasdaq: IPGP  ) 25% Jan. 10 -- 20.3% 1%

Source: Fool.com, all returns as of market open, June 27, 2012, returns include dividends.

In some cases, these jumps were the result of earnings releases, but that wasn't true for IPG, Solazyme, or Stratasys.

We're all about buying stocks with the intent of holding them for the long term here at the Fool. If you'd like to find out what three stocks will be leading the new industrial revolution, I suggest you check out today's special free report. Inside you'll get the name and tickers of three companies leading the 3-D printing revolution. Get your copy of the report today, absolutely free!

Fool contributor Brian Stoffel owns shares of all the companies mentioned in this piece. You can follow him on Twitter, where he goes by TMFStoffel.

The Motley Fool owns shares of Solazyme, IPG Photonics, Apple, and Whole Foods Market. Motley Fool newsletter services have recommended buying shares of Whole Foods Market, Stratasys, IPG Photonics, and Apple, and creating a bull call spread position in Apple. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (16) | Recommend This Article (32)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 28, 2012, at 8:38 AM, StopPrintinMoney wrote:

    buy and hold no longer works. it worked until 1980's. Look into SP500 graph that goes back to 1900's and you will see what I mean.

  • Report this Comment On June 28, 2012, at 9:30 AM, Zonker wrote:

    Brian,

    Can't wait for the follow-up article:

    The No. 1 Reason to NOT Be a Buy-to-Hold Investor - A study of the 5 year performance of the Million Dollar Portfolio at the Motley Fool.

    Cash would have been a better strategy.

  • Report this Comment On June 28, 2012, at 9:48 AM, troym72 wrote:

    Here's the major flaw in your logic. For the last 10 years the market has done NOTHING. So, buy and hold over the last 12 years had gotten you jack squat. How can you deal with that as an investor without getting in and out and try to hit the ups and downs. I'm 40 years old and I'm not willing to wait another 15 years for the market to go up on a consisten basis again.

    It makes me so frustrated when people use this "buy and hold" fallacy, assuming that the market will always go up.

    Look at the market in 2000, look at it now. It has done NOTHING for 12 years. Hello?

    If you go back to the period from about 64 to 82, the market basically did NOTHING that entire time. That's 18 years of no returns. NONE. How did buy and hold work for the people who were turning 40 in 1964 - IT DIDN'T.

    You can't just sit back and wait for the market to turn itself around. You have to act. You have to make your margins somewhere. And, if you prefer buy-hold, that is great, but sometimes you have to trade if you want to retire.

    Sorry for the rant. :-)

  • Report this Comment On June 28, 2012, at 9:50 AM, TMFCheesehead wrote:

    @StopPrintinMoney-

    If you include dividends reinvested it still works quite well. Even since 2000, where the S&P 500 is DOWN 10% w/o dividends, the buy-to-hold investor who reinvested dividends is UP 13%.

    Dividends make a difference.

    Brian Stoffel

  • Report this Comment On June 28, 2012, at 9:55 AM, TMFCheesehead wrote:

    @troym72-

    In addition to my above comment, investing in quality companies at reasonable prices can provide returns that vary greatly from the S&P 500. But as I pointed out with SSYS, SZYM and IPGP, you can't always tell when the big moves will happen.

    Brian Stoffel

  • Report this Comment On June 28, 2012, at 10:05 AM, troym72 wrote:

    @TMFCheesehead. I would hardly call being up 12% over a 12 year period a "working" investment model. Really? I can't retire making 1% per year on my investments. Laughable indeed.

  • Report this Comment On June 28, 2012, at 10:20 AM, TMFCheesehead wrote:

    @troym72-

    Regular investments at the beginning of each year starting in 2000 (aka dollar-cost averaging--which is a more realistic view of the issue for someone still earning a salary and saving money) would have returned a total of just under 30% w/ dividends reinvested.

    Since 2000: 13%

    Since 2001: 26%

    Since 2002: 39%

    Since 2003: 74%

    Since 2004: 40%

    Since 2005: 27%

    Since 2006: 20%

    Since 2007: 4%

    Since 2008: 0%

    Since 2009: 52%

    Since 2010: 22%

    Furthermore, I suggest you look at Morgan Housel's work on this piece. Part of the reason returns have been so low is that there was 20 years of growth squeezed into just a few years in the mid-to-late 1990's.

    Brian Stoffel

  • Report this Comment On June 28, 2012, at 10:30 AM, TMFCheesehead wrote:

    Just to follow up on those numbers, look at the returns from the 1990's

    1991: 302%*

    1992: 215%*

    1993: 204%*

    1994: 184%*

    1995: 188%*

    1996: 180%

    1997: 132%

    1998: 73%

    1999: 35%

    *doesn't include dividends

    Brian Stoffel

  • Report this Comment On June 28, 2012, at 11:22 AM, DonkeyJunk wrote:

    My confirmation bias makes me love these articles.

  • Report this Comment On June 28, 2012, at 12:26 PM, daveandrae wrote:

    I have been around the block enough times in this business to know that buy and hold equity investing, feels, very much like having an inoculation.

    Either a person gets it right away and begins practicing it, more or less, for the rest of their lives, or, there is simply nothing. This is yet another reason why so few control so much.

    To suggest that the market hasn't done anything over the last ten years is inane to the point of laughable. Ten years ago, McDonald's was trading as low as 13 bucks a share. Today, not only is the share price bumping up against 90, but the 2002-03 cost basis dividend yield is approaching 22%.

    I know, because not only was I buying shares ten years ago, but I'm still holding onto my position, today. This irrefutable fact only reinforces my firm belief that there is absolutely, positively, NO correlation whatsoever between "investment performance" and Investor Return.

  • Report this Comment On June 28, 2012, at 3:58 PM, Darwood11 wrote:

    Hmmm, wasn't there an allegory about the tortoise and the hare?

  • Report this Comment On June 29, 2012, at 5:02 PM, Zonker wrote:

    Brian,

    Why are you ignoring and refusing to answer the case study at the Motley Fool aka The Million Dollar Portfolio that proves that Buy and Hold Investing DOES NOT WORK!... You have proven it here at the Motley Fool. Get your head out of the sand, man up and address it!

  • Report this Comment On June 29, 2012, at 5:28 PM, Hawmps wrote:

    Wow... all the comments about how B & H doesn't work. It seems to me that the posters are looking at a very narrow timeframe and not considering cycles of general P/E expansion and compression. We have ben in P/E compression since dot.com.

    Also, consider demographics and who is putting money into the market and who is taking it out... baby boom/bust is also a cycle.

  • Report this Comment On July 01, 2012, at 1:59 PM, TMFCheesehead wrote:

    @Zonker-

    I have only been following the MDP recently, and I know that Ron Gross hasn't been running it for its entirety.

    Regardless, you are looking at one simple data point of a portfolio that hasn't even been around for five years. Investing is a decades-long process.

    Brian Stoffel

  • Report this Comment On July 05, 2012, at 5:37 PM, Mliaom wrote:

    Buy and hold quality companies and then trade around the core positions in volatile times is the way to go, IMO. No one is 100% right.

  • Report this Comment On February 15, 2013, at 10:02 AM, RegLeCrisp wrote:

    Lots of folks putting their retirements on the line. If this is the voice of the common investor there will be a lot of retirees eating mac and cheese at best, FancyFeast at worst.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1926263, ~/Articles/ArticleHandler.aspx, 9/20/2014 10:27:56 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Apple's next smart device (warning, it may shock you

Apple recently recruited a secret-development "dream team" to guarantee its newest smart device was kept hidden from the public for as long as possible. But the secret is out. In fact, ABI Research predicts 485 million of this type of device will be sold per year. But one small company makes Apple's gadget possible. And its stock price has nearly unlimited room to run for early-in-the-know investors. To be one of them, and see Apple's newest smart gizmo, just click here!


Advertisement