You Bought, Now You Have to Hold

Last Updated Apr 4, 2009 5:15 PM EDT

With the terrible stock market of the last year, many are wondering if a buy and hold approach is still the best investment strategy for their stocks. The answer is yes, assuming you are well diversified. By diversified, I mean your portfolio of stocks looks something like the S&P 500, which covers all major sectors of the economy.

A buy and hold approach relies on the long term trends of economic growth and expansion. As the economy expands, corporate profits generally grow, and thus the stock market generally rises in value.

The frustrating part about the process is that the relationship between profits and stock market values isn't linear. Sometimes market values increase more than profits, sometimes they fall faster than profits, and sometimes they don't keep pace with profits. Over shorter term cycles, this has often been the case. Wealth accumulation is a volatile process.

But over the long term, profits have grown and market values have grown. While there are no guarantees for the future, this is the trend that you are banking on when you use a buy-and-hold approach, and it is a strategy that has a high probability of success for your retirement money.

Consider the 30 year period from 1962 to 1991. The first 20 years were pretty bad. We had several bear markets, including the big one in 1973-1974, and then runaway inflation. Over those 20 years the stock market grew by about 6.8 percent a year. Not bad, but well below its long-term average of 10 percent.

But over the next 10 years, the market went on a tear and returned about 17.6 percent a year. This rapid expansion raised the long term return over the 30 years to about 10.3 percent. Thus, for money invested in the 1960s, the money ultimately received a good rate of return, but investors had to be patient.

Stock-market values lagged improvements in corporate profits until the mid-1980s. By then, investors felt more confident about the future and bid up the price of stocks to reflect the better earnings reality.

If you have a basic faith in our markets and the ingenuity of the American economy, then buy and hold a diversified portfolio. There is plenty of historical evidence to support your strategy.

If you don't use a buy-and-hold approach, then you must trade your way to profits. This is a dangerous strategy because it relies on your ability to predict market movements and outsmart the rest of the world. As Clint Eastwood said, "a man has got to know his limitations." People who get wiped out have usually adopted aggressive trading strategies and found out the hard way that they were not smarter than the rest of the world. Do the names Bear Stearns, Lehman Brothers or AIG ring any bells?

To my knowledge, there is no credible evidence that trying to predict market movements is a profitable way to invest over the long run. I know a buy and hold strategy is hard to accept at times, but it really is the only strategy that you can rely on.