Abandon Buy and Hold at Your Peril

06/04/2009 2:48 am EST

Focus: MARKETS

Howard Gold

Founder & President, GoldenEgg Investing

“Buy and hold” investing is dead.

That chant has been getting louder and louder over the past year as global markets went into a free fall, before their recent rally.

Markets have changed profoundly, the reasoning goes. Investors who simply bought stocks and held them saw their portfolios decimated in the bear market. In volatile markets like ours, where information spreads instantaneously, investors need to be more active—even become traders—using brand-new instruments like exchange traded funds to hedge their portfolios just like the institutions do.

The evidence shows, however, that this argument is specious at best and self-serving at worst. And ironically the ideas are gaining currency just as global markets may have hit bottom. Investors who follow this questionable advice now may wind up making things worse for themselves.

And by pushing this strategy, advisors are overlooking the real problem: Going into the bear market, many investors were insufficiently diversified and had far too much of their money in stocks, as we discussed here last week.

Still, after circulating around independent advisors and newsletter writers for the last year, the “buy and hold is dead” theory has hit the mainstream media big time.

“Many advisers are questioning their faith in long-standing investment principles, such as controlling risk by building diverse portfolios,” The Wall Street Journal reported recently. “Some have ramped up their use of opportunistic trading to try to profit from short-term rallies and sell offs.”

And late in May, The New York Times chimed in: “A new mentality has emerged among some investors, who are rethinking the traditional approach to asset allocation. The upheaval in the markets and in the broader economy has led them to question long-honored principles of investing and to sound a death knell, at least for now, for the buy-and-hold mind-set.”

Indeed, “buy and hold” has few defenders now—maybe only Warren Buffett, John Bogle, and a few old-school value managers and advisors.

But that’s pretty typical near the end of bear markets. “Everybody said ‘buy and hold’ was dead in 1973 and 1974,” recalls Dan Sullivan, editor of The Chartist newsletter. “But it was the best time to be a buy-and-hold investor.”

And in a recent compelling commentary in the Financial Times, Dennis Butler, president of Centre Street Cambridge Corp. in Cambridge, Mass., wrote: “The present situation is not unlike the early 1980s, when 15 years of stagnation caused equities to fall out of favor. Like their counterparts of today, promoters…pushed ‘opportunistic’ trading strategies, usually involving options and futures contracts. But the pervasive pessimism of 1982 preceded one of the greatest equity bull markets in history.”

And by abandoning “buy and hold” right now, investors not only might be jumping ship at precisely the wrong time; there’s no evidence that trading more aggressively will work, anyway.

Two academics, Brad M. Barber of UC Davis and Terrance Odean of UC Berkeley, have done extensive research on individual investors and traders, and their findings should deter even the hardiest souls from going that route.

You might recall their 1999 paper in which they studied the trades of 66,465 US households with accounts at a large discount broker. From 1991 to 1996, some of the best years of the 1990s bull market, “those that traded most earned an annual return of 11.4%, while the market returned 17.9%.”

Investors, they say, are overconfident in their own abilities to make winning trades. “Those who trade the most are hurt the most,” they wrote. “Our central message is that trading is hazardous to your wealth.”

Barber and Odean then joined with two Taiwanese scholars to do an even more comprehensive 2006 study.

They got records of every trade made in Taiwan from 1995 to 1999 and found that “the aggregate portfolio of individual investors suffers an annual performance penalty of 3.8 percentage points” and that “virtually all of individual trading losses can be traced to their aggressive orders.”

“Trading in financial markets leads to economically large losses for individual investors,” they said, pegging those losses at $US 32 billion during the period studied, or $US 6.4 billion annually. “This is equivalent to a staggering 2.2% of Taiwan’s gross domestic product,” they wrote.

Meanwhile, they found, institutional investors racked up “abnormal returns of 1.5 percentage points after commissions and transaction taxes.” Their conclusion: “Individuals lose, institutions win.”

When I caught up with Professor Barber this week, he acknowledged that cultural factors—including a propensity among Chinese investors to view stock trading as a form of gambling—may have played a role in the results, but don’t account for most of individuals’ underperformance. He says the Taiwanese findings are in line with data from other countries.

He concedes that some individuals can consistently beat the market, but the number is shockingly low—less than 1% of all the day traders they studied in Taiwan. (I happen to think the number is higher here, but good traders require a different mentality and skill set than investors have.)

“There’s simply no evidence trading helps investors,” he told me. “I’m still a big fan of buy-and-hold investing. Pick the mix of stocks and bonds that’s comfortable to you and stick with it.”

I know that’s little consolation to the millions of Americans who have watched their retirement plans go up in smoke. Indeed, if you bought and held only stocks, you did very, very badly last year. If you bought and held some individual stocks (like, say, AIG, Fannie Mae, Bear Stearns, or General Motors), you might have lost everything.

But as we wrote last week, the most rudimentary, no-brainer 50/50 split between stocks and bonds helped you survive the recent “lost decade” just fine—even if you put all your money in on January 1, 1999 and did nothing else except reinvest the dividends for the next ten years.

Of course, you don’t need a financial advisor or newsletter subscription to tell you how to do that. But you may feel you need a sherpa to guide you through the treacherous world of triple-inverse ETFs, commodities ETNs, fundamentally weighted indexes, etc. No wonder so many advisors are urging you to trade actively—with them, of course.

Maybe the underlying problem was just that people bought and held the wrong things—they put too much in stocks and not enough in everything else.  Let’s not blame “buy and hold” investing for our own mistakes.

Howard R. Gold is executive editor of MoneyShow.com. The views expressed here are his own.

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