Defending Buy and Hold

On 04/08/2011, in Investment Strategies, by Jordan Wilson
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In my last post, I listed three legitimate concerns about the buy and hold strategy.

Buy and hold will not allow for the maximum possible returns, it does not protect one’s wealth in down markets, and it does not work for short to medium holding periods.

Definitely areas to watch out for, but less of a problem than some articles state.

I will explain why below. 

1970s NASDAQ Performance

A commonly used example to show the worthlessness of buy and hold involves the performance of the NASDAQ in the 1970s.

To quote from Richmond Asset Management, “Consider the NASDAQ market crash of 1973-1974. The NASDAQ reached its high peak in December 1972. It then dropped by nearly 60 percent, hitting rock bottom on September 1974. We did not see the NASDAQ break permanently free of the ’73-’74 bear market until April 1980. Buy-and-hold did nothing for investors from December 1972 through March 1980. Investors would have made more money during this period in a 3 percent savings account. History repeated itself with the recent 77 percent drop in the NASDAQ from 2000-2002.”

Almost the same wording can be found at Turtle Trader, as well as probably many more websites. It is a good example.

But does it truly destroy the buy and hold argument? I am not sure that it does.

One of my rules is to always check the numbers myself. Especially when the other party has their own agenda. You can often arrive at vastly different conclusions depending on the start and end cut-off points for data. Always keep this is mind when reviewing numbers.

On December 5, 1972, the NASDAQ (IXIC) closed at 133.75. While it is true that it took until April 1980 to fully recover, there were numerous prior dates where the NASDAQ exceeded 133.75. In August 1978, April 1979, July 1979, August 1979, etc. But citing those dates ruins the narrative that buy and hold destroyed the entire 1970s.

Next, let us review the NASDAQ’s subsequent performance. Not just for the 7.5 years cited by the naysayers, but for longer periods.

By April 1, 1980, the NASDAQ had recovered to close at 139.90. No returns for 7.5 years. Not good, I admit.

But what if you held until April 2, 1990? A 17.5 year time frame. Yes, you lost over the initial 8 years, but the NASDAQ did very well in the 1980s. On April 2, 1990, the NASDAQ closed at 420.10. A holding period gain of 214%. About a 6.8% annual return.

Add another 10 years, and on April 3, 2000, the NASDAQ closed at 3860.66. An increase of 2786% since December, 1972. Your annual return is now 13.0%.

And on April 1, 2011, the NASDAQ closed at 2789.19. An increase of 1985% from 1972. An average annual return of 8.2% since December, 1972. And from the above cited data, this period included the years when the NASDAQ fell 77% from 2000 to 2002.

I will not look in detail at returns from buying earlier than December, 1972. Especially because the NASDAQ only goes back to February, 1971 when it opened at 100.0. But had you bought at the initial trading date, by April, 1980 you would have returned 3.8% annually. By April, 1990, a 7.9% annual return. And by April. 2011, an 8.7% annual return.

While your returns would have been better by accurately timing the market movements, over medium to longer time periods the buy and hold strategy remained viable. Even when those periods encompass two huge crashes.

In fact, if we look at historic returns between 1925 and 2004, we see that even the 8.2% annual return during a period with two substantial bear markets still outperformed U.S. inflation, Treasury Bills, and longer term bonds. So perhaps the buy and hold, even in down markets, is not as worthless as some people claim.

But Active Management Would Have Worked Better

True.

If you are proficient at identifying the right assets and timing market or asset volatility, active management is the better investment strategy.

However, as we have seen in previous posts, active management tends not to outperform passive management in the long run.

Part of this is the increased costs of active trading and management fees should you have someone trade on your behalf.

But a large part of the underperformance is the simple fact that it is extremely difficult to accurately time market movements.

Even if you attempt to follow the recommendations of leading analysts, you may not be successful in the long run.

How many smart (i.e., professional) investors got caught in the NASDAQ bear market of the 1970s or early 2000s? A lot. You can research the number of funds that were caught in the tech bubble and were disbanded.

How will you know when to divest? Or when to jump back into the market?

The professionals are not able to time the swings very well. Will you?

And Active Management Provides Protection in Down Markets

If you can accurately time the market, yes.

But that is hard to do as we have just discussed.

If you do not time it correctly, you will not protect your position and you will incur costs at the same time.

You may also experience an opportunity cost in not owning the asset when it does rebound in price and you either do not buy back in or buy back too late. This opportunity cost can have a significant impact on portfolio performance.

So what should you do to safeguard your wealth against market volatility?

I have a few suggestions on how to to optimize the buy and hold strategy to deal with these legitimate concerns.

Some I have already discussed. Some may be new.

We will cover these next time.

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