Rethinking the Buy and Hold Strategy
Jul 17th, 2008 by Nut
First of all, let me remind everyone that I am a Warren Buffet disciple when it comes to investing — I believe that, when it comes to individual stock investing, what matters is the long term performance of a company. I am not a trader: I’m not interested in making a quick buck or in the day-to-day gyrations of the market. So even with all the bad news that’s out there right now, I’m OK — I just put more money into my Roth IRA. It means I’m getting more of my portfolio’s equities on the cheap. But when it comes to individual stocks, I’m starting to see some evidence that maybe buying and holding isn’t such a great idea after all.
Individual Stocks vs Index Funds
Most of my holdings are in index funds — I truly believe they are the best, most efficient, and simplest way to invest in the stock market (again, in the long run). But I do a lot of research to invest some of my money (around 10-15%) in individual stocks. Why? I also believe that, if you do the research and remain disciplined, individual stocks can help boost your index-fund portfolio. Let’s face it, most index funds (mine track the S&P 500, mid-cap stocks and foreign markets) aren’t going to gain 30% in one year. Individual stocks, on the other hand, can sometimes achieve that kind of hefty return. That reward comes with added risk, but those are the breaks. My individual stocks are only there to supplement my overall holdings.
Buy and Hold
The quick and dirty version: you buy a stock and hold on to it for a long period of time because, over time, stocks tend to do well (it’s the reason why people like myself by index funds). In the short term, a stock you think is a good investment could tank because of rumors, bad press, nervous institutional investors, etc. Any number of things that have nothing to do with the quality of the business can send the stock plummeting. If you’re buying and selling, you may wind up selling (or buying) at the “wrong” time. The idea behind buying and holding is you mitigate that risk by holding on to the stock for a long time.
I used to believe wholeheartedly in this, especially since no one can time the market. And because you can’t time it, you don’t know when it’s safe to “get out,” or sell the stock. Right?
Stocks that Work Like Index Funds
Before I move on to knowing “when to sell,” I also want to mention that there are individual stocks out there that function almost like index funds. They are highly diversified and, over the long run, have had great results. This is the stock chart for Procter & Gamble, one of those stocks you hear about over and over and over. It’s a diversified company that is considered “safe” and has proven itself time and time again. The stock chart doesn’t lie — it’s done great over the past 35 years. Plus Warren loves PG so that’s also a good sign. But PG is the exception rather than the rule. You could hold on to Procter your whole life and you’ll probably come out OK. Another examples is Warren Buffett’s Berkshire Hathaway, which I actually own.
As for any other of the thousands of stocks out there, knowing when to sell is nearly impossible.
When to Sell?
Why am I reevaluating my thoughts on the buy-and-hold strategy? I’ve been seeing way too many stocks that have returned to levels where they were five, six, even ten years ago. That means that a buy-and-hold investor has gained absolutely nothing (barring dividends) over that time span. Not good.
Let’s take a look at an example:
That’s the stock chart for Crocs, the once-popular squishy-shoe maker. The stock did fantastic up to the end of last year, and then in just collapsed. Sure, some of it is the economy, but some of it was the company itself — their one product was a trend whose time was up. How were you supposed to know that? A buy-and-hold investor probably wouldn’t have invested a significant amount of money on such a young company with little history to go on, but if they would’ve they would be hurting right now. You may have heard a comment or two from someone saying that the shoes were stupid and that they wouldn’t be caught dead in them anymore now that everyone and their mother had a pair. But does that really warrant selling off your stock? Or maybe you hears someone on CNBC say something bad about the company.
In retrospect, it’s easy to fool ourselves into thinking, “I would’ve known to get out back then.” The reality, however, is wholly different.
Now What?
Let me say it again even though you’ve heard it a million times: you can’t time the stock market. I think the only lesson here is that, while buying and holding can be incredible risky, it’s probably the best way to go. The downside should make investors even more picky about where they put their money. Like Warren says, when you buy a stock, pretend you’ll be holding it forever. That would’ve protected you from investing in something like Crocs (I hope).
In the end, our greed and desire for outstanding returns may be too great to hide behind the buy-and-hold strategy. I understand — looking at some of the companies out there that have started small and then shot up over shorter periods of time is tough to handle psychologically. I’ve been thinking about trying a strategy with certain stocks where I buy and hold — until I hit a preset return.
Buying and Holding…with a Catch
The idea here is that, instead of trying to time the market, you set a timeline of selling at a predetermined number. Let’s say you bought stock in Crocs at the end of 2006 when it was around 20 and you told yourself “I’d be real happy here with a 20% return.” That may be a little too greedy (I’d probably be happy with a 15% over a year’s time), but let’s see what would’ve happened.
You would’ve gotten your 20% return in just a few months — fantastic! BUT you would’ve felt like an idiot because you missed out on the 235% return you could’ve gotten. While that’s frustrating, what would’ve made you get out at the top? Setting a 235% return is not very realistic. Getting out at this predetermined 20% would save you the hassle of thinking you can time the market (which you be very stressful). So you missed out on a 235% return — that happens all the time. But you can’t complain about a 20% return in a few months.
Anyway, that’s just an idea I’m considering, I haven’t put it into practice just yet. I’d love to hear what everyone else thinks about it and the buy-and-hold strategy in general.
*all the stock charts were taken from Yahoo! Finance
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The first comment I would make is that it’s important to make sure it’s clear that when people say stocks will rise over time (given as sufficiently long period) it means the general collection of stocks. It does not mean any specific individual one, or even a sector.
Stocks represent businesses. Businesses rise, become stable, and sometimes fall, and their stocks do the same. One cannot assume that any given stock will rise in the long run because it may not. Invariably, some of them are going to fall and never recover.
The other thing I would say is that you’ve basically contradicted yourself here. You make it decidedly clear that you don’t believe in market timing, but yet what you propose in terms of taking a 15% or 20% profit when it comes along is exactly that. You’re talking about trading, plain and simple.
I seriously doubt Buffett would condone that kind of behavior.
If you buy stock in a company you judge to be a good investment you hold that stock until your opinion changes. By putting a price target on things you automatically tie yourself in with the vaguaries of the shorter-term price action. You could wait years and and years for that objective to be hit and make some incredibly paltry return as a result. Meanwhile the stock could go up by leaps and bounds beyond your target after you got out, which would have made the long hold worthwhile.
My general point is that if your are investing then invest. If you want to trade, then trade. You can do both, but each needs to be handled seperately.
Precisely. You need to prepare to hold, but you also need an exit strategy. Whether it’s something like an index fund that you prepare to sell off gradually to fund your retirement or whether it’s a stock that you’re going to hold until its price goes up $10/share. Then you know when to get out. The latter may not make as much if the stock goes up $20/s total, but it’s better than coming back down after the $20…below $10.
It’s not a bad idea, but that’s really more of a trading strategy. Traders aren’t interested in business fundamentals, just stock numbers. A buy-and-hold investor should be interested in the business.
I think it’s be better to set goals based on valuations. Croc may’ve gone up 20% in a few months, but how did their earnings do? If you buy at a P/B of 2, maybe say you’ll sell if P/B hits 2.5. Or use the P/E ratio, or other factors.
buy-and-hold is often touted because so many investment strategists use a “long term” historical basis that goes back to 1980. 1982-2000 was the longest, most consistent and strongest bull in history. its never coming back or repeating itself. take the historical basis back to the late 60s and you start to see how buy-and-hold falls apart. we’re all market timers. no one invests in something for forty years, even in index. just accept that the market presents opportunities to people who understand the oscillations between over and under valued for example, this week fnm and fre were seriously undervalued. also wm. going into any of these just this week would have paid you out in a volume many other investments need a decade to do
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benevuto, I actually have and am really interested in checking it out. I’ve heard good and bad about it, but I’ve definitely got my eye on it.