FOOL ON THE HILL
Buy-to-Hold Isn't Dead

Self-styled market gurus appear in every market downturn to deplore (but not define) buy-and-hold investing and advocate short-term trading strategies instead. Swiss money manager Felix Zulauf is the latest. Nothing's wrong with short sales or special situation stock investments, but, even if you can consistently trounce the market averages, taxes and commissions still make you a loser.

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By Tom Jacobs (TMF Tom9)
March 4, 2002

[This column was updated on 3/5/02 to reflect capital gains from an index fund sale after 20 years.]

Many financial writers, money managers, and even some very sharp members of the Fool community proclaim that buying and holding stocks for the long term is a failed strategy for investing now. Here's yesterday's advice from Swiss asset manager and committed Bear Felix Zulauf in The New York Times:

"I think we are in a structural bear market that will last for 5 to 10 years...What is important for the investor is that the winning formula of buying and holding is not working anymore. In fact, it is working against him. If you cannot be successful in the current environment, get out. Leave it to those who can. This is a market for opportunistic investors who can play rallies and can also play the short side. But it is important to know what you are doing if you short stocks." (As Zeke Ashton points out in "The Art of Short Selling," leading off the latest issue of The Motley Fool Select.)

My first Foolish reaction was to turn the page, because with at least 15 years to retirement, what happens over the next five or ten years doesn't affect my strategy. As painful as the last two years have been, nothing has changed the fact that the average return from stocks over every rolling period of 20 years or more since the 1920s exceeds all other asset classes, whether bonds, gold, or real estate.

You might have to wait those 20 years, but if you are willing to, you can obtain that average market return simply by investing in a broad market index fund and taking a long nap, like Rip Van Winkle. If you choose instead to invest in individual stocks of good businesses selected with care, the longer you hold the greater the chance you have of meeting or exceeding the averages.

It matters what price you initially pay, but a longer holding period can help heal all valuation wounds as well as reduce taxes. Buying-to-hold means not holding blindly, either, but being alert to changes in the businesses and other, better opportunities. That's why whenever I hear a self-styled financial guru attack the idea of buy-and-hold-no-matter-what, I see only a strawman erected to promote the guru himself. That happens in every  market downturn, as Fool alumnus Randy Befumo exposed in August 1996!      

Despite this self-confidence, I did not turn the page. Why not? Because no one can afford blindly to ignore the possibility that he might be wrong, and the only way to learn and grow is to question assumptions. What if Zulauf is right, the world has changed, and the sole means to ensure good long-term results is to take a short-term strategy for the next five to ten years? Stranger things have happened.

Put it to the test
I decided to grant to Zulauf and other doomers the benefit of the doubt and agree that the way to make money in stocks has indeed changed for the next five to ten years. The rules are now to "play rallies" (buy low and sell high, market time by buying at the bottom and selling at the top, swing trade) and sell short. Let's assume he is right, and also that you and I can do this successfully.

The ground rules
First, you could "play rallies" in an IRA, in theory, because you have no tax consequences, but not in a 401(k), because it's the rare plan that allows you to buy and sell individual stocks -- outside of your company's, of course -- and even when it does, certainly not for a discount brokerage commission rate. But because we cannot sell a stock short in either a 401(k) or IRAs, we rule them both out. Our Rally-Short Genius investor can only play the short-term strategy in a taxable brokerage account.

Taxes and commissions cut into short term gains
In a taxable account, we will have to take capital gains taxes into account. Since we will be following a short- term strategy, we will have gains from stocks held less than one year, and they will be taxed at the highest marginal rate. Let's use the four rates highest for 2001 -- 27%, 30%, 35%, and 38.6% -- for short term capital gains taken in years 1-5, 6-10, 11-15, and 16-20, respectively, assuming that rising income puts us in higher tax brackets as we progress in careers.

Let's also add a 6% state capital gains rate. This is an average of all state capital gains rates, taking into account the few states that do not tax income or capital gains and that some states tax at higher rates. Keep in mind that short sales, as Roy Lewis explains, are always taxed at the highest rate because they are treated as being held for the shortest possible time.

       Short Term Capital Gains Tax Rates
               Federal         State
Years 1-5        27%           6%
Years 6-10       30%           6%
Years 11-15      35%           6%
Years 16-20      38.6%         6%

And for commissions, I'll assume 10 trades a year at $14.95 a trade. You can find lower and higher commissions from discount and other brokers, so this is an average. Because  commissions are added to the cost of your shares, I reduce the $149.50 a year by the combined federal and state short-term capital gains tax rate.

Benchmark: We can always hit the market averages
We must measure our success against a benchmark. We can always just stash our cash in a low-expense index mutual fund or exchange-traded fund that follows a broad market average, such as the S&P 500 or broader still, the Wilshire 5000, and snooze. These funds have low turnover, so our taxes will be negligible. Historically, the broad stock market has returned an average 11% over 20-year rolling periods, before taxes, but let's assume Zulauf is right that the game has changed. I like to use 6% over the next 20 years, the more conservative of the 6% and 7% long-term outlooks presented by Berkshire Hathaway (NYSE: BRK.A) CEO Warren Buffett in two notable Fortune pieces.

Our benchmark for the Index Fund Snoozer investor is a compound annual growth rate of 6%. 

Assume we can beat the averages
Lastly, we have to figure that we can handily beat the averages for the next five to ten years using strategies that Zulauf espouses. We'll be wildly optimistic and figure that we will double the market's average return of 6% for the first five years, beat it by 50% for the next five years and 25% for years 11-16, and match the market average for years 15-20. This really is generous, keeping in mind that I know only one mutual fund manager, Legg Mason's Bill Miller, who has exceeded the S&P 500 for more than 10 years. In sum:

              Rally-Short   Index Fund
             Genius Return Snoozer Return
Years 1-5       12%           6%
Years 6-10       9%           6%
Years 11-15      7.5%         6%
Years 16-20      6%           6%

And the winner is...
Starting with $10,000, comparing the estimated returns for playing rallies and short selling versus a sleepy index fund, here are the results:

                           Rally-Short Index Fund
                           Genius      Snoozer 
Starting amount            $10,000     $10,000
Total after 20 yrs.         25,540      32,071
Gain:                       15,414      22,071
Compound annual growth rate   4.80%         6%
Taxes: Snoozer sells @20 yrs. 5,071
Gain: 26,995
Compound annual growth rate 4.80% 5.1%

The Index Fund Snoozer wins handily if she does not have to sell and could leave the money until death. But she's also ahead if she decides to sell at 20 years, perhaps for retirement needs. She wins the new superlong-term capital gains rate of 18% for assets purchased in or after 2001 and held for over five years. Let's assume she doesn't move to no-tax Florida, so we'll apply a 6% state capital gains tax rate. This lowers her 20-year return from $32,071 to $26,995, or a still-fine 5.1% CAGR. I've posted the complete table on the Fool on the Hill discussion board (30-day free trial to read, subscription required to post).

These numbers could change absolutely but not relative to each other, if, say, you do better or worse in a given year or if the 20-year average annual return from an index fund is better or worse. The index fund still wins, and that's not even including the opportunities foregone by spending hours and hours following the short-term movements of the markets. Index Fund Snoozer has had many more hours to spend with family and friends, expand education or professional capabilities, coach kids' teams and otherwise volunteer, float down the river in an inner tube, and post better investing results.

We need to be open to any strategy that can increase our wealth for the future, and I'm not against the occasional short sale or special situation for the short term -- I've done both. I just haven't seen enough analytical support for a shift en masse to a different strategy for the next five or ten years, when taxes and commissions reduce even the most extraordinary results below the returns from the safe, sleepy index fund alternative over a hypothetical 20 years. 

For now, the conclusion is that Zulauf simply needs Zoloft.

Have a most Foolish week!

Tom Jacobs (TMF Tom9) does not own a cummerbund, so the Nobel is out. At press time, he owned no shares in companies mentioned in this story. To see his stock holdings, view his profile, and check out The Motley Fool's tip-top disclosure policy.