Fool Answers: Is Buy-and-Hold Dead?

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Q: Is buy-and-hold an outdated strategy?
The buy-and-hold investing philosophy makes sense in "normal times." But is it really the best approach now that we may be in a recession of unprecedented magnitude? -- Signed, Itchy Trigger Finger

A: Stop me if you've heard this one before: Since 1926, a whole lot of bad things have happened -- the Great Depression, World War II, the Cold War, racial tensions, assassinations, presidential impeachments, oil embargoes, and now this: WTF 2.0* (as I like to call it until the news networks officially come up with a name). Since that time, the stock market has delivered a compound average annual return between 9% and 10%.

That's the standard reply that financial writers, advisors and massage therapists are obliged to give. With that out of the way -- and likely providing a lot less comfort than a Snuggie and a stiff drink -- let's dig deeper and ask the obvious question: If not buy-and-hold, then what?

Market timing, that's what!
The only real alternative to buy-and-hold is market timing -- timing your purchases based on the short-term movements of the market (or of a specific stock). The goal is to buy at the bottom when prices are cheap, sell at the peak, and take your profit -- getting in, getting out, getting in and out, ad infinitum.

You want to know how well has that strategy works in real life? Paint me unimpressed.

Our resident research junkie, Rule Your Retirement's Robert Brokamp, cited a study in this month's issue that reveals the best-case-scenario for market timing:

A 2005 study titled "A Comparison and Evaluation of Market Timing Strategies" found that before transaction costs, all but one of the strategies studied beat a buy-and-hold strategy. "In pure return terms," wrote the authors, "the best rule, based on the difference between the earnings-price ratio and short-term Treasury yields, earns average returns of 0.96% per month (12.1% annualized), compared with 0.94% [11.9% annualized] for buying and holding the equity index." I don't know about you, but a strategy that beats the market by 0.2% a year before transaction costs and taxes doesn't sound too impressive to me -- and that's the best one.

I'm with you, Robert: If I'm going to switch to an investing strategy that requires full-time babysitting and 24-7 shackles to the computer and CNBC, a zero-point-something-percent advantage just doesn't cut it. That brings us back to buy-and-hold drawing board.

Why the best subscribe to buy-and-hold
From Benjamin Graham to Warren Buffett to Peter Lynch to the investing icons with names my spell check doesn't recognize, the truly great investors are marked by their long-term commitments to their investments.

No wonder. For quality-of-life reasons alone, taking a long-term view frees you up to:

• Concentrate on what you love. Look for solid companies through old-fashioned fundamental research, then find the ones you want to go into business with as stockholders.
• Keep your wits about you during temporary setbacks. Too many investors get shaken out of a great investment -- and robbed of enormous gains -- when they get the jitters.
• Save money on commissions and taxes. That money can be put to use in other promising investments, instead of penalizing the returns of those who trade in and out of stocks.

Not just anyone can be a buy-and-hold investor, either. It's a critical edge that small investors have over big institutions, according to Aswath Damodaran, an award-winning professor of finance at New York University. Here's what he said in an interview with our Motley Fool Hidden Gems newsletter service in 2005:

A Fidelity or a State Street can't afford to hold onto stocks for five years. They have too many competitive pressures forcing them to be much more short term. You or I own our own portfolios. We can buy and hold with two constraints. One is liquidity. The other is you have got to get your spouse to agree to whatever you bought. And those are surmountable, right?

Consider the institutional ownership of these top-tier companies (as of last quarter):

Source: Yahoo! Finance.

You get the gist, right? The little guy (that's us!) can make a mint feeding off of their castoffs and reap the rewards that come from the ability to hold on to our shares in good times and bad.

A strategy that's better than buy-and-hold
Despite being an easier sell to your spouse, and statistically a safer bet, we do concede that the whole buy-and-hold mantra is not perfect. "Buy and hold" oversimplifies the underlying philosophy: Too many people misinterpret it as "buy-and-hold-on-no-matter-what" -- the kind of thinking that leads to holding on to the losers in your portfolio for way too long. (See "Why You Should Sell" if that describes you.) That's why we have a slightly different spin on that crusty old buy-and-hold approach.

"Buy TO hold" better reflects the true intention of the founding fathers of long-term investing. When you buy to hold, you commit to sticking it out for as long as it takes your investing thesis to fully play out. Hopefully, that's at least three or five years, or longer. Anything less tends to lead to ulcers. (For those with a decade to spare and a bent toward income-producing stocks, here are 10 dividend stock ideas to consider.)

However, if something happens to upend your original thesis, bought-and-sold is the way to go.

When to switch to the bought-and-sold strategy
"Sell" is not a four-letter word in Fooldom. If we make a mistake in our business analysis, or if the company moves in an altogether different direction than we expected (and not a good one), we sell.

Sell criteria should not be based solely on what the market is doing at any point in time. It's all about each company in your portfolio and your long-term investment thesis. Buy-to-hold investors are concerned with game-changing events -- things that wipe out a company's competitive advantage or stress out a company's underlying financials beyond repair.

Game-changing events happen in good times and bad. Perhaps a failed drug trial halves a pharmaceutical company's share price, or a rumor about a new technology drives up a company's share price to unsustainable heights.

While your aim should be to sell as rarely as possible, ultimately, buy-to-hold simply means doing your homework, finding great businesses you want to stick with for a while, and checking in regularly to revisit your investment thesis or rebalance.

Get real answers: Got a pressing financial question? Simply type your question in the comments field below, or email us at [email protected]. We cannot respond to every question we get, particularly ones about specific investments (our lawyers make us say that). So to increase your chances of getting your question answered on Fool.com, keep it fairly broad and relevant. And sign it with a funny name.

*WTF 2.0: We're Traumatized Forever. What did you think it stood for?