Does Buy And Hold Work?

Question From A Reader

A reader has asked me to comment specifically on an article that recently appeared in The Globe and Mail titled, ‘With funds, buy and hold doesn’t always pay off’ written by Mr. Rob Carrick. You’ll probably need to read the article to put my answers in context. (I don’t really have anything negative to say about it, but if you read through the comments at the bottom of the Globe article there are some readers of the Globe who took issue with it.) Specifically, the reader mentioned that her advisor always touts the buy and hold philosophy and she was beginning to question the blind practice of this strategy.

The Quick Answer

Long answer short: buy and hold is the way to go, so long as you are in the right investments and understand the ride you can and should expect when investing in equities. Trying to time the market, or constantly switching between strategies or investments more often than not produces sub-standard results.

Food For Thought

One of the questions posed by the author was to ask if readers thought 5 years or even 10 years was a good, long time to hold a fund (in order to reap the benefits of equity investing). He then goes on to show some funds that have had poor performance during this time. This is actually quite good from an educational perspective: consider a post that I wrote earlier which indicated that some academics indicate that you may need 30 years before you can say with statistical confidence that stocks will outperform T-bills. And in actual historic performance, T-bills outperformed US stocks for 17 years from 1964 to 1981. If you are going to invest in equities, you need to be prepared for years of negative performance (perhaps even decades although this would be extremely, extremely rare). Given that even the largest stock market in the world (the US) can have years of negative performance, it is worth looking into diversifying into other markets. Of course, staying the course is really a matter of easier said than done!

A Wrinkle…

Since this article is dealing with actively managed funds, then there is an extra variable to consider: relative performance of the manager versus the peer group and the index. In the context of the article, you certainly need to pay attention to the manager’s relative performance. It’s a given that equities can have long periods of negative performance, but periods of relative underperformance (even if the absolute performance is positive) is an investing sin – but can also occur over short periods of time. I’m not much of an ajudicator of active funds, I gave that up a while ago, but the logic that a longer leeway should be afforded to managers with longer track records seems prudent. Even Warren Buffett can underperform his benchmark during short timeframes.

Side Note

I suppose there is one minor point to which I might offer up an alternative approach. Mr. Carrick suggests that with newer managers, it would be best to let them demonstrate good performance for a while before investing your money with them (in the hopes of benefitting from their good performance after they have established themselves as being worthy). An alternative would be to just stay away from them altogether since research has shown that newer, unidentified managers who provide good performance will eventually lose this ability as more and more money is given to them. One way of thinking about this is that if a manager has $50 million dollars worth of good ideas per year then they look great when they are managing $50 million dollars. But as the fund grows organically and then from money invested by new investors, perhaps the fund is now worth $500 million. $50 million of good ideas and $450 million worth of less than good ideas doesn’t seem so attractive.

Conclusion

In the end, if you are investing in actively managed funds I think the article raises good points. If you are still unsure about your advisor’s recommendations, it never hurts to get a second opinion (or a third). If you would like to subscribe to Rob Carrick’s RSS feed you can click here for the feed details.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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  • Mark Wolfinger

    Preet,

    I agree that trying to time the market is a bad idea. But, I also believe that buy and hold is an idea whose time has past.

    Why would anyone be willing to invest under circumstances in which one may have to “be prepared for years of negative performance, perhaps even decades.” Decades?

    When the markets tank, they tank. But an investor can be prepared. There are option strategies one can adopt that increase the probability of earning a profit (vs. buy and hold) every year. When the markets surge, buy and hold is better. But at all other times buy and hold lags.

    The strategies: Collars for the most conservative; covered call writing for those who want to maintain a bullish stance. And other strategies are available that depend on the investors investment goals, tolerance for risk, and comfort zone. Learn more: http://blog.mdwoptions.com/options_for_rookies/

    Mark

  • Preet

    @Mark – good to hear from you, and appreciate the comment. Perhaps I made it sound worse than I believe it to be, as the likelihood of negative performance persisting that long is relatively low, but it can happen. Also assuming that an investor diversifies across different equity markets, then stretches of underperformance in any one market can be offset by other markets covered in the portfolio. While the different portfolio constituents may be moving in different cycles, over the long term they can be expected to each have a positive return, while occasionally moving in tandem enough that the entire portfolio has negative periods (kind of like right now!). The concerns over longer periods of underperformance were more centered on individual markets (actually I will amend the post to reflect this).

    With respect to option trading, yes I practice option trading for some clients, but not many. I do talk about covered calls and sometimes naked puts and collars, but beyond that if a client can understand these things they may not need an advisor for investments, perhaps only the financial planning! :)

    I certainly encourage people to visit your blog on option strategies, and you are certainly much more an authority on option trading than I could ever imagine to be, but for those not in the industry, it’s a pretty rare breed that can take to option trading without first taking a long, long time to educate themselves – which few are willing to do.

  • Mark Wolfinger

    I agree. Too many option rookies want to jump right in. It’s crucial to learn to understand how options work before trying to use them (or any other investing tool).

    That’s why people like you are needed – to provide good guidance and good advice.

    Keep up the good work.

    Mark

  • Xenko

    “Think five years is a good, long time to hold a fund? Then you should know that 241 mutual funds of all types have lost money annually on average over the five years to July 31. Does a decade sound like a better bet? Okay, but 133 funds have been money losers over the past decade. Fifteen years? There are eight funds that have been money losers over that period of time, and there are three that are underwater over the past 20 years.”

    That is a quote from the article that is distorting the reality of the situation. So over 5 years, 241 funds lost money… out of how many funds? 1,000? 10,000? In 2002, the Canadian government reports that there were approximately 2,000 Mutual Funds in Canada (http://www.fin.gc.ca/toce/2003/cmfi_e.html).

    So making the assumption that the number of mutual funds in Canada was constant over the past 20 years (not accurate, but I don’t have ready access to the data I’d need):
    Over 5 years: 241/2000 = 12.05% of all funds lost money. Not great, but you have a 9 in 10 chance of making money, so not bad.
    Over 10 years: 133/2000 = 6.65% of all funds lost money.
    Over 15 years: 8/2000 = 0.40%
    Over 20 years: 3/2000 = 0.15%

    Basically, a little context from Rob about what pool of funds he looked at would give the article a little more credibility, but it would probably make his argument harder to believe.

  • Preet

    @Xenko – a very valid observation. I believe this same point was raised in the comments of the original article which is why I omitted it from my post. Also clouding the fact (to his credit) is that funds that have long underperformed are not included in today’s analysis. To which I wonder why the companies who own those funds haven’t wound them down! :)

  • thickenmywallet

    I sit in Mark’s camp as well. I give the notion of buy and hold in funds or stock less and less weight as the movement of capital increases cross-border. When Bear Sterns can collapse in a week, its up to us as investors to keep alert all the time and know what is happening around us and make the appropriate adjustments (with their advisors of course!)

    Certainly, I am not supporting day trading but actually watching your portfolio and make adjustments is required. Even Buffet will on occasion shake up his portfolio.

  • Preet

    @TMW – Sounds like an argument for holding a world market portfolio. The fall of Bear would in and of itself be hardly noticeable in such a portfolio (of course the financial sector’s decline would be very noticeable!). Part of the problem is when do you decide to make these active calls, and where do you draw the line? Not that I’m against it, I think a prudent investor can have no problem making these distinctions. But Buffett is the poster boy for buy and hold – I don’t have the exact info in front of me, but I’m guessing you can count on one hand how many times he’s sold positions. Anyone know?

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