Buy-and-Hold Investing Is Not Dead

Last Updated Jul 27, 2009 8:51 PM EDT

Buy-and-hold investing is dead. At least that's the take I've read from Wall Street Journal to the New York Times and seemingly every media outlet in between over the past few months. But as a general principle, whenever investors hear that the "death knell" is sounding on a particular approach to investing, they'll probably be best-served if they embrace whatever is being pronounced dead. And abandoning buy-and-hold -- in favor of what, flip and ditch? -- seems to fit this theory nicely.

Before we proceed too far, let's distinguish between those investors who found that they were taking on too much equity risk, and have sold a portion of their stock investments in favor of a more conservative asset allocation, and those that are exiting the market with the expectation of buying back in at some point in the future. The former group has learned some hard-earned lessons and is, ideally, taking them to heart; the investors in latter group, who are being described in the articles above, are merely trying to outsmart the market.

Of course it's not surprising that the theory of buy-and-hold is being questioned in the wake of a brutal bear market. Very few investors take issue with the approach when the market is rising -- holding is easy when your investment is increasing in value year-over-year. But when bear markets hit, many investors find they're much like the infamous car rental agent from Seinfeld; we learn that "buying" is the easy part, it's the "holding" that's difficult.

And it makes a certain amount of intuitive sense to bail out when the market falters. Why hold on when it seems obvious to everyone that the market slide will continue? Why not sell now, minimize your losses, and buy back in when everything calms down?

The most obvious criticism of that approach is that for every single seller of stocks who believes that now is the time to get out, there's a buyer on the other side who believes precisely the opposite. One will be wrong, and the other will be right.

Secondly, if you're bailing on the stock market with the expectation of getting back in, exactly what sort of scenario will persuade you to do so? When the market is down another ten or twenty percent? Hardly. A further decline will only heighten the alarm, keeping the bear market on the front pages with story after story full of quotes from experts who see no end to the carnage.

Instead, you'll probably only feel finally comfortable after a marked increase in the market -- like the one we've benefitted from since March -- waiting out a rise long enough to ensure that you're not buying into a dead-cat bounce. The result ? You'll almost inevitably be buying back into the market at a price that's higher than when you exited.

While jumping in and out of the market as it bounces around might comfort us psychologically by providing the impression that we have some control over something that's inherently mysterious and uncontrollable, the fact of the matter is that investors are not very good at timing the market's ups and downs.

A few weeks ago I described how mutual fund managers' decisions to buy and sell during the recent market downturn negatively impacted their funds' returns, and last week I covered the terrible market-timing record of ETF investors, so it should be of little surprise to find that mutual fund investors are hardly covering themselves in glory, either.

According to Morningstar, the average equity fund earned an annual return of -1.5 percent for the five years ended June 2009. Mutual fund investors, however, earned a return of -2.3 percent for the same period, meaning that the typical investor earned a return that was more than 50 percent worse than that earned by their funds largely because of their poor attempts to time the market's ups and downs.

So the next time you read about someone pronouncing the death of buy-and-hold investing, keep in mind that, after Winston Churchill, history has demonstrated that buy-and-hold investing is the worst strategy for building wealth, except for all the others that have been attempted.

Image via Flickr user David Paul Ohmer CC 2.0

  • Nathan Hale

    View all articles by Nathan Hale on CBS MoneyWatch »
    Nathan Hale has spent decades working in the financial services industry, during which he has researched and written extensively about personal investing, the mutual fund industry, and financial services. In this role, he uses a nom de plume because many of his opinions about the mutual fund industry and its practices would not endear him to its participants.