Why Buy-and-Hold Doesn’t Work

March 25, 2009 at 1:00 pm by Tom Lydon      Bookmark and Share

The “long run” is something of a hopeful illusion that will take markets, stocks, exchange traded funds (ETFs) and the economy at large to a better point later on. But investing for the long-term – buying-and-holding – does not work. Why?

As Peter Bernstein for Financial Times reports, states a number of reason why buy-and-hold simply doesn’t work anymore

  • The S&P 500 has underperformed long-term Treasury bonds for the last five-year, 10-year, and 25-year periods, and by substantial amounts. As the data implies, the capitalist system as we know it would come to stop – the long run expected returns on bonds are actually yielding higher then equities.
  • Sure the S&P provided a total annual return of 13.1% from the end of 1949 until 2000, but what does that tell us about what lies ahead? Nothing. What happens in the market is not random – each event is the result of preceding events, and they can’t be replicated.
  • There’s no precedent for what happened in 2008. The speed and depth of the decline were unanticipated by most It’s made the unknown even more unknown than it’s ever been.

The truth is, nobody really knows what lies ahead for investors or markets. The tried-and-true historical view has been deemed unreliable at this point. There isn’t anything to “bank upon” and the buy-and-hold strategy is dead.

“The long run” is a mystery, and it always will be. Instead of hoping the markets will trend up over time, why not become a trend follower? We rely on the 200-day moving average to determine when we’re in and out. Such a strategy gives investors the chance to take advantage of any potential long-term uptrends, as well as avoid the lion’s share of any long-term downtrends.

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  • Fresh eyes
    As a young person strait out of university this is the way I see it:

    A Buy and Hold strategy is gauranteed to be a part of every rally. The only difference with trend following is when you choose to be out of the market. If you are confident that by selling your position you can repurchase at a lower price in the future then this will be profitable. However, this is basically a short selling strategy. If you short every time you sell out of the market you should be able to make money. If you could be profitable running this short selling strategy then you will be underperforming a buy and hold strategy. Since it seems like short selling is something that most people can't do profitably over the long term, maybe buy and hold does in fact make sense.....with proper diversification of course.
  • Jeff
    I've been following the posts that Tom and the folks over at IndexUniverse.com have made concerning buy-and-hold versus trend following, and his strategy of using 8% stop losses to minimize the downside seemed intriguing. The main problem, however, is if you look at the volatility of just about every major ETF out there, their standard deviations are MUCH higher than 8%. SPY, for example, has a 3-year standard deviation of over 15%, and the 1-year is even higher, so you're going to be stopped out of the position pretty frequently, and that raises the potential to get whipsawed as well as the problem of when to get back into the position.

    Really, the bottom line is that there is no perfect solution. And there are always going to extreme years like 2008 that very few anticipate. But longer term I've got to believe John Bogle's mantra of determining your risk tolerance, diversifying like crazy and going for the market return minus expenses is the better way. If the timing/trend following method is so good, who are the historical investors of this school and what is their long term record? I'll bet you'll be hard pressed to find one that beat the market longer term.

    No doubt Tom's strategy paid off in the past decade, but just about the time we read about it and digest it, it changes again. You've got to ask yourself what are the odds that it will be the same or even similar the next 10 years. It is an interesting subject, nonetheless!
  • HI Jeff- Your comments are valid but there's no doubt that a trend following strategy would have dramatically protected portfolios in the past ten years. Going forward, as the market rebounds, the 200-day average will give investors the ability to select those asset classes that may provide the best opportunity for future gains. The 8% volatility aspect may stop out positions during a long uptrend, but that assumes the newly available cash is not put to work in other asset classes as their new trends develop. Finally, the lack of capital appreciation over the last twelve years in the stock market has been devastating but the emotional toll to investors have been worse. I submit that a trend following strategy would help investors financially and emotionally going forward.
    Respectfully,
    Tom Lydon
  • backtester
    I have performed a very rigorous historical study of market timing over the past 18 years. The timing signal is based on the 200-day and 50-day moving averages of the SP 500 index. If the 50-day average moves above the 200-day average you buy the SP 500 index the next day at the average of the high and low values. If the 50-day average drops below the 200-day average you sell the SP 500 index the next day at the high-low average price.

    I don't have room here to describe the details of this study but there are a couple of interesting conclusions. This method did an excellent job of protecting you from most of the big losses associated with the major market drop that began in 2000 and also the most recent market drop that began in 2008 while getting you back in at a much lower level than where you got out. That's the good news.

    However, since this timing method is based on detecting changing trends, it always misses the beginning of a new trend. Thus, unless the downtrend is prolonged and deep, you will often lose a little whenever you are out of the market compared to the buy-and-hold investor. Over time these small losses can easily accumulate to a level where they wipe out the large benefit you receive when the less frequent large downtrends occur.

    Even worse than this, however, is the question of whether you might become discouraged over these small but accumulating losses and abandon the plan just before the next big downturn occurs. In that case you could end up far worse off than the buy-and-hold investor. The moral of the story...there's no free lunch...
  • Thank you for your comment!
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