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Why Buy-and-Hold Isn't a Good Strategy

This may seem like a strange title coming from me, but it's true. Let's explore why.

The investment world is generally broken into two camps:

  • Those who believe in active strategies (stock picking and market timing)
  • Those who believe in a passive, or "buy-and-hold," strategies
The problem with this simplistic view is that buy-and-hold is used as a convenient "shorthand" for a passive investment strategy (accepting market returns by using vehicles like index funds). However, a passive investment strategy doesn't mean being totally inactive regarding the management of the portfolio.

The first and most obvious reason why buy-and-hold is a bad strategy is that ignoring the impact of market movements on your asset allocation means your portfolio will drift away from its targeted allocations. Thus, whenever the market causes drift, you must rebalance to maintain your risk profile. This can be done by setting minimum and maximum allocation ranges in your investment policy statement (IPS).

For example, if you have a 60 percent equity allocation, perhaps you would create a tolerance range of 65/55. This means you would buy more stocks if the equity holdings fell below 55 percent and sell some stocks if they rose above 65 percent. (Note that rebalancing should be done on a risk basis, not a time basis such as quarterly or annually).

And for taxable accounts, the right strategy is to harvest losses for tax purposes whenever they exceed stated levels (such as 5 percent or $5,000). So, buy-and-hold should really be called buy, hold, rebalance and tax manage throughout the year (not just at year-end).

Another reason buy-and-hold isn't a good strategy is that many elements go into creating an IPS and determining your appropriate asset allocation, among others:

  • Job stability
  • Investment horizon
  • Your willingness to take risk
  • Your need to take risk
  • Your marginal utility of wealth
When these assumptions change, the only logical thing to do is to re-evaluate the plan to see if the asset allocation is still appropriate. For example, a large inheritance will cause the need to take risk to fall, allowing you to take less equity risk. Of course it may also increase your ability (or even willingness) to take risk. Numerous events could cause shifts as well:
  • A birth or death in the family
  • A marriage or divorce
  • A change in job status
  • A disability
And I'm sure that in 2008, many investors learned they were overconfident of their stomach's ability to deal with the acid produced by bear markets, overconfidence being a common human error.

The bottom line is that while a belief in market efficiency does lead investors to adopt a passive investment strategy, it doesn't mean you shouldn't be active in managing the portfolio and the overall plan. It means you're not actively picking stocks or timing the market. It also means that you need to be active in terms of rebalancing, tax-loss management and regular review of your plan to make sure it still fits you and your circumstances.

More on MoneyWatch:
The Advice Remains the Same What You Should Know About Rebalancing Don't Believe the Hype About Gold Are Stocks Really Doomed? Don't Confuse Strategy With Outcome

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