Buy and Hold Works--If You Let It

The buy and hold debate, which we've stoked on Morningstar.com over the last couple of weeks, has suffered from a curious stumbling block: namely, what is the definition of "buy and hold"? It's difficult to debate whether something works or not--whether it's alive and well, or dead and buried--if you can't agree on what it is, exactly.

So just to muddy the waters a bit more, I'm going to throw my own recipe into the mix. However, given the lessons we've learned about this debate so far, I'm going to start with my definition of buy and hold.

And just so I don't hold you in suspense, the answer is no, it's not dead.

However, I also don't think it's a be-all and end-all. By itself, it has its weaknesses, but there are ways to overcome them and tilt the odds in your favor. And for that reason, buy-and-hold shouldn't be your only slogan, but it can be the one with the biggest typeface. It just needs some supporting context to make it work.

What My Dictionary Says About Buy and Hold
To believe in buy and hold is simply to believe that certain riskier assets, such as stocks, require longer holding periods in order for you to consistently realize higher returns versus other investments.

This is not to say that you won't get lucky and buy a stock that shoots up 20% or more in a week's time. But what has the potential to shoot up so fast also has the capacity to crater just as quickly.

So, to make sure that your upside potential overcomes the downside risk, history proves that these assets need some breathing room. Have the patience to fall one or two steps back before going three or four steps forward. Ibbotson data shows that a diversified basket of stocks (in this case, the S&P 500) has provided a total return of 9.7% on average every year from 1926 through August 2010, versus 5.6% for long-term government bonds.

Did you see those words "on average" in the last sentence? They probably should be in italics, because they're pretty important. Behind the scenes of those average annual returns are some good years, even some great years, but also some years that stunk up the joint. Just because they've outperformed over time doesn't mean that stocks haven't suffered bouts of poor performance--sometime even years of it.

But that's the whole point, right? You have to accept the risk of stumbles, and the actual stumbles (and yes, even the falls, too), in order to reap the rallies. Is it worth it? History says yes. Over time, the stock market climbs more stairs than it falls down.

And that's where the "hold" part comes in--and why it's so important. You've got to be willing to hold your stocks over the long term in order to maximize your odds of climbing more than falling, of beating those other asset classes.

This requirement for a longer time horizon is why I think it's so funny when I hear someone say, "Buy and hold didn't work in 2008."

To me, that's like checking a pot roast half-way through the cooking time and declaring the recipe didn't work.

So, What About the Lost Decade?
Ah yes. The lost decade for stocks. Well remember earlier when I said buy and hold wasn't perfect by itself? Let's talk about why.

To be sure, stocks can suffer severe and protracted periods of underperformance. They can get stuck in the mud and go nowhere. The last 10 years is a good case in point. If you had invested all your money at the beginning of 2000, this article is probably not helping your heartburn.

This is an important point: On its own, buy and hold has its weaknesses, and one of them is entry and exit risk (or more commonly, the risk of buying high and selling low).

The ultimate benefit accrued by buying and holding stocks can be severely weakened if you buy them at a premium. And certainly, because riskier assets have a higher potential for volatility, there is a very real risk that you will buy stocks at the wrong time (i.e., when they are overvalued).

And if you do buy at a steep premium, holding the asset over a long period of time won't necessarily help you recoup your losses, let alone start realizing a profit. Think about that rare Beanie Baby you ponied up for at the height of the Beanie Baby craze. Twelve years later, it's still in the back of your guest room closet--and it's still worth about 1/100 what you paid for it. (So just give it to your dog already!)

But as an investor, you don't have to play this high-stakes timing game. You can even out your odds of paying a fair price for stocks by dollar cost averaging--that is, investing small amounts of money into the stock market over time. If you invest a small amount of money consistently every month, you'll likely overpay at times when the market is running hot (like the tech bubble). But you'll also pay a fair price at other times, and sometimes you'll underpay for your investments (or get more for your money) when the market is depressed, such as in 2008. Over time, these overpayments and underpayments should net out to a fair average.

Dollar cost averaging removes the risk of going "all-in" at exactly the wrong time. Of course, you also give up the possibility of going "all-in" at just the right time, but very, very few people (and I'm talking about the pros here, too) can do that consistently. Plus, most of us have a long accumulation phase; we don't have a huge chunk of money to invest at any one time anyway. Our potential investment dollars are coming in small doses with each paycheck, making them natural candidates for DCA.

And by the way, the same dollar-cost averaging logic can work on the sell side, too. When you're ready to exit an investment, if you slowly draw it down, you avoid the risk of selling everything at exactly the wrong time--namely at the bottom of a recession.

 

Tickers Don't Pay the Bills
And speaking of selling, the point of a portfolio is that someday you will sell those investments and use that money for something�college, retirement, a second home.

But although it's not mentioned in the term "buy and hold," having a strategy for selling is critical to making sure you maximize those long-term benefits of buying and holding that I talked about earlier.

A bad selling strategy can really hinder the execution of buy and hold, and it might even make you believe buy and hold doesn't work. For instance, even if you didn't have the bad timing to enter the market at the height of the tech or housing bubbles, you still suffered if you had to make any large-scale sales out of your stock holdings during the subsequent downturns. It stings to see your portfolio drop in value, but it really hurts to lock in those losses by selling. Yet many, many investors did just that in 2008--either out of panic or necessity.

But there's also a pretty simple fix for this: Have a strategic portfolio plan, with an appropriate asset allocation for your time horizon. And have a defined path to make that allocation more conservative as you get closer to that college enrollment, retirement, or beach house in Boca.

One way we've seen this put in practice is the bucket approach to portfolio management:

In a long-term bucket are more aggressive investments (your buy and hold investments: stocks). These are housed in a part of the portfolio that you do not need to tap in any big way for many, many years. This allows these assets to rise, fall, swoon and recover, but ultimately appreciate over time.

A second bucket may be in intermediate-term bonds or similar investments. These holdings are expected to be tapped over intermediate time horizons. Because these investments are less volatile over shorter time periods than the assets in bucket 1, the odds of them being extremely depressed or extremely overvalued when you need to sell or buy them are much lower. But the trade-off of this steadiness is that they also provide a lower return over time.

A final chunk of the portfolio is in extremely safe, very liquid investments--the short-term bucket. These investments are regularly tapped for expenses. Since they have almost zero volatility, you needn't worry about them being overvalued when you add money to them or undervalued when you take money out--though the trade-off for this strong steadiness is that they provide very little return potential, especially in today's low-yield environment.

How does this help you practice buy and hold with more success? Well, because you know you have liquid (and stable) assets to tap for your immediate needs, there's no forced selling of stocks when they're depressed to cover your everyday expenses. And because you know you have stable, liquid assets to cover those immediate needs, it should cut down on panic selling, too.

It's More Active Than It Sounds
One of the inherent misunderstandings about buy and hold is the notion that there is just one action, a purchase, and then inaction, indefinite holding. But if you are employing buy and hold as part of a bucket approach or other strategic asset allocation strategy, you won't just be sitting on your hands. You will be actively managing your portfolio in a couple of ways.

First, you will need to build up and periodically replenish the short and intermediate term buckets as retirement approaches and begins. You will actively redirect more contributions from your paycheck to those safer buckets as you get older, and you will also likely need to sell some of your stock holdings and buy bonds as your target allocations become more conservative. But that process occurs gradually, over time, as you age, meaning you can again benefit from dollar-cost averaging out of your stock positions and into your bond positions, mitigating that aforementioned exit and entry risk.

Second, at regular intervals, you must rebalance your portfolio if your asset allocation gets off target. This effectively trims positions that have done well and ballooned in your portfolio and adds to positions that may have underperformed and diminished in your portfolio. My colleague Christine Benz calls this "tactical light." In effect, it is doing the same thing that those quick-trading market-timers are trying to do (that is, buy assets when they're cheap and sell them when they're pricey). But rebalancing just does it in a gradual way, using smaller bets, spread over many years of rebalancing--with a lot less risk.

Consider the following: If investors had been trimming stocks and rebalancing to their bond holdings as equities bubbled at the start of this decade, it may not have been a lost one after all (or at least it wouldn't have been as painful). Now the opposite may be occurring: History suggests that after a bad decade, stocks tend to come back, yet investors' money is flowing today into bond funds, not necessarily as part of a strategic allocation, but likely due to the zero yields in money market funds, performance chasing, or risk aversion.

If this big bond bet doesn't pay off, yield-seekers who moved out of cash into bonds will have imperiled their liquidity and might be forced to sell bonds into a down market for their immediate cash needs. Those who are chasing bonds' past performance will face disappointment at fixed-income's failure to indefinitely outperform. And the risk-averse who fearfully reallocated out of stocks into bonds will miss out on any concurrent stock rally and will have in fact introduced another risk, namely that their portfolios are now too conservative to meet their long-term growth needs.

It Works--If You Let It
If you believe the tenet that riskier assets come with higher rewards--that investors will, over time, be repaid for the risk they take on--then you should believe that a buy-and-hold strategy can pay off for you. But you have to put a framework in place that mitigates those attendant risks and lets time smooth out those ever-choppier returns.

Set up a portfolio plan that addresses (or will address) your immediate and intermediate needs. This allows you the flexibility to have a hands-off home in your portfolio for buy and hold investments: that long-term bucket. And when you fund that bucket, spread your risk with a dollar cost averaging strategy. This will mitigate the terrible hangover in those lost decades.

And remember that pot roast. Sure it needs some attention here and there. You've got to lift the lid now and then. But mostly you just gotta let it cook.