Buy and Hold Is Overrated

05/10/2012 8:15 am EST

Focus: STOCKS

While buy and hold investing sounds safe and stable, if you're not reinvesting your dividends or ignoring market trends, you're not doing your portfolio any good, writes Michael Dever of Brandywine Asset Management.

In 1999, global stock markets were at the peak of an 18-year secular bull market. Buy-and-hold had become a mantra.

That’s no big surprise. At that time, there was no doubt that a person who had bought and held US stocks over a long period would have made more money than in almost any other investment.

But that belief was neither rocket science nor sound investment advice. It was merely a simple observation. Yet books, articles, and investment semi­nars, by the truck­load, were produced that expounded on the benefits of buy-and-hold.

For many people, the validity of the buy-and-hold myth has shriv­eled, along with the values of their stock portfolios, throughout the secular bear market that began in 2000. For many oth­ers, though, the buy-and-hold approach continues to be a rally­ing cry, and is continually touted as being a virtue and the ultimate strategy.

However, buy-and-hold is not a viable strategy at all; it is merely a way to rationalize losses.

Let’s first review the historical results upon which this myth is based (using data pro­vided by Robert J. Shiller, author of the bestselling book Irrational Exuberance). Since the start of 1900, US equities produced a real average annualized return of 1.82% if dividends were spent, rather than reinvested, and a 6.27% real annualized return with divi­dends rein­vested.

The “real” return adjusts the performance for the negative effects of inflation, which reduced the returns by more than 3% per year on average. If we were to look at the “nominal” return, the amount stocks earned before adjusting for inflation, the returns jump to 4.92% if dividends were spent and 9.51% with dividends rein­vested.

We look at the numbers with and without the reinvestment of dividends to stress the importance of reinvesting dividends. For various reasons, such as the fact that people are taxed on dividends and want to have the money available to pay taxes, many people do not reinvest their dividends. As the data show, over time, this neglect will cost them the vast majority of their cumulative profits.

On the surface, the nominal return, with dividends reinvested, seems to fit the definition of “healthy.” Someone placing $100 in US equities at the start of 1900 and holding tight for the next 111 years, reinvesting all dividends, would see their portfolio grow to a stunning $2,383,810 by the end of 2010. It clearly demonstrates the power of compounding, which Albert Einstein said was one of the greatest human creations he had known.

Even after adjusting for inflation, the ending value of this portfolio is $85,598. This is still an outstanding return. Taxes would reduce these returns further, but are not included in these calculations due to their ever-changing nature and vary­ing impact on each person.

What is obvious from the data, however, is that the major­ity of the real returns did not come from stock price apprecia­tion, but from dividends. If, rather than reinvesting the divi­dends, a person spent them instead, the real value of the port­folio at the end of 2010—111 years later—would be only $744.

The chart below illustrates the real (inflation-adjusted) growth in an initial $100 placed into a basket of US stock at the start of 1900, assuming dividends are spent and not reinvested. This will undoubtedly concern people who have been told, as long as they’ve been alive, that stocks work best over the long-run.

chart
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The most interesting observation here is that it took until 1950 before the value of the initial $100 ex­ceeded and stayed above that $100 value. This means that for more than 50 years, any person who placed $100 into a broad basket of US stocks (such as IBM, KO, CAT, JPM), and did not reinvest his or her dividends, would have suffered a loss, al­lowing for inflation. This really does give new meaning to the term “long run.”

However, perhaps even more is the fact that all of the real stock market re­turns earned over the past 111 years can be attributed to just an 18-year period—the great bull market that began in August 1982 and ended in August 2000. Without those 18 years, the real, in­flation-adjusted re­turn of stocks, without reinvesting divi­dends, was negative!

This highlights the greatest risk of the buy-and-hold strategy, which is that stock market returns are extremely “lumpy.”

Related Reading:

Hershey: Dividends Can Be Sweet Indeed

A Clean Dozen Dividend Stars

The Compelling Case for DRIPs

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