The Evidence Against Buy and Hold, and Why You Should Do It Anyway

Put on black, cue the dirge, and join the procession. Buy-and-hold investing is dead. Or so we're told.

After all, broad-market investments such as the S&P 500 SPDR (NYSE: SPY) have lost money over the past decade. Hold on to an investment for 10 years, and still lose money. What more proof do you need that such a strategy is for suckers?

Ask a pro
Over the past few weeks, I've been asking the fee-only financial advisors in the Garrett Planning Network -- some of whom are offering Motley Fool readers a limited-time 10% discount -- for their take on various financial-planning topics. They've shared their thoughts on who should convert a traditional IRA to a Roth and how to estimate whether you're saving enough to retire. I also asked whether they thought buy-and-hold investing was dead.

Ed Schrotenboer had a few things to say on the topic. As a Certified Financial Planner and a fellow who's been preparing tax returns for 30 years, he's seen a lot. "The buy and hold philosophy is a simplification of a very complex investing world," he says. "Not only is our world more complex than in the past, but the tech bubble and housing fiasco show once again that we are still human and our emotions still affect our investment decisions and move markets." Schrotenboer offered three pieces of evidence that should put caution in the heart of any buy-and-holder.

1. Japan
The U.S. stock market isn't the only one that lost money over the past decade. The iShares MSCI Japan Index (NYSE: EWJ) lost even more.

And that's not the worst of it. The overall Japanese stock market is still down 70% from its 1990 peak, despite Japan's being the second-largest economy in the world.

2. Price matters
One tenet of the buy-and-hold strategy is that you hold your investments, no matter how pricey. Yet there's plenty of evidence that shows a correlation between market valuation and subsequent 10- and 20-year returns. "Because the investment world is complex, nobody knows the short term return on equity investments," says Schrotenboer. "But a look at history shows that returns over the following decade are poor when the beginning price-to-earnings ratio is high."

Where are we right now? According to the website of Rule Your Retirement contributor Doug Short -- who breaks up historical market valuation into quintiles -- the current U.S. stock market is bumping up against the most expensive 20%. Stocks are definitely not cheap.

3. The history of individual stocks
Your take on buy-and-hold investing depends on your understanding of exactly what that means. Are we talking broad asset classes -- such as international stocks or corporate bonds -- or individual stocks? If the latter, then Schrotenboer has some food for thought. "For those investors who invest in individual stocks, it would appear that the buy and hold forever strategy would have some significant limitations. As an example, I know way too many investors who trusted General Motors and just believed that it would come back."

He also cites a study by Blackstar Funds which found that, from 1983 to 2006, just "25% of stocks were responsible for all of the [U.S. stock] market's gains." The majority of individual stocks -- just like the majority of actively managed mutual funds -- underperform the market. The study also featured the returns of some of the best stocks of the boom era, and their returns after the bubble popped. Here's a sample:

Source: "The Capitalism Distribution" by Eric Crittenden and Cole Wilcox.

Buying and holding worked very well on the way up. On the way down, not so much.

But what's the alternative?
Given the evidence cited above, you might think that Ed Schrotenboer doesn't recommend a buy-and-hold strategy for his clients. But you'd be mostly wrong. He still thinks buying and holding is a viable strategy, as long as you throw in regular rebalancing and plenty of diversification, as well as factor in such criteria as valuation into a client's asset allocation.

"I have a long discussion with my clients about how they will manage their money," he says. "This is part of the process of developing an Investment Policy Statement (IPS) that places in writing their decisions about how their portfolio will be managed. This discussion includes current market conditions, including price levels. An investor needs rules on how he manages his portfolio. The beauty of buy and hold is the rules are very simple and easily implemented. Following rules eliminates a lot of emotional mistakes."

If you don't buy, hold, and rebalance, what do you do? Day trade? Follow your gut? Listen to the contradictory talking heads on CNBC? These strategies don't have impressive histories.

The truth is, "buy and hold" is a bit of a misnomer; very few people practice -- or advocate -- buying a handful of investments and never, ever making any adjustments. But investing in several types of asset classes -- stocks and bonds, small caps and large caps, foreign and domestic -- combined with regular rebalancing and getting gradually more conservative as the investor ages does work. In fact, such a strategy did make money over the past decade.

However, if you didn't make money over the past decade, maybe it's time to hire an objective, independent professional like Ed Schrotenboer to help you, or at least give you a second option. That's the great thing about these fee-only advisors; you hire them only for the services you need. If that sounds good to you, visit the Locate an Advisor page of the Garrett Planning Network and click on your state. To get that 10% discount for Fool readers, look for the advisors with a Motley Fool logo next to their names.