Buy and Hold: Still Alive and Well

Meet Bill. He invested $10,000 in an S&P 500 (INDEX: ^GSPC) index fund 10 years ago and checked his account balance for the first time yesterday morning. He's elated to see his investment is now worth $19,590 after all dividends were reinvested.

Bill knows a thing or two about market history. He knows that, historically, he earned a good return -- 7% a year, or close to average. He remembers that during that decade we endured two wars, a housing bubble, a collapse of the financial system, the worst recession since the Great Depression, 10% unemployment, a near shutdown of the government, a downgrade of U.S. debt, and Justin Bieber. Through it all, he managed to nearly double his money without lifting a finger.

"Buy and hold works wonders," he thinks to himself.


But then he starts reading market news. Almost without exception, he finds that commentators have declared buy and hold dead, using the last decade as proof.

Buy and Hold Is Dead (Again) is the title of one popular book. "Holding an index or mutual fund for decades will not work for today's investor as spikes in volatility and risk can quickly wipe out any gains," one article warns.

"The only way to make money in the equity market is to be nimble, and that means adopting a strategy that is not buy and hold," he reads. "Buy & hold is a relic of a bygone era when the economy was stable and consistent growth was the norm," another analyst laments.

"What are these people talking about?" Bill wonders. He spent the decade visiting his kids, taking trips to the beach, reading good books, and enjoying life -- and managed to double his money all the while. These professionals, it seems, spent the decade poring over financial news, trading obsessively, stressing themselves relentlessly, and they're bitter about the market.

Bill knows why they're bitter. They didn't double their money. They likely lost money. Most traders do -- a fact he's well aware of. The only people who think buy and hold is dead, he realizes, are those frustrated with their inability to follow it.  

Bill is fictitious, but the numbers and analyst quotes here are real.

Going back to the late 19th century, the average subsequent 10-year market return from any given month is about 9% a year (including dividends). If you rank the periods, the time from August 2002 to August 2012 sits near the middle of the pack. What we've experienced over the last decade has been pretty normal, in other words. This goes against the thousands of colorful buy-and-hold eulogies written in the last few years, but it has the added benefit of being accurate.

And even it understates reality. The S&P 500 is weighted toward the market cap of its components, a quirk that skewed it toward some of the most overvalued companies in the last decade. An equal-weight index -- one that holds every company in equal amounts and provides a better view of how companies actually performed -- returned more than 140% during the decade.

Why have so many declared buy and hold dead? I think it's all about two points.

First, if Bill started investing just two years earlier, his returns through today would be dismal. 2000 was the peak of the dot-com bubble; 2002 was the depth of its aftershock recession. Bill started investing when stocks were cheap, setting him up for good returns today. The majority of today's investors, who likely began investing during the insane late '90s, have fared far worse.

But that doesn't prove buy and hold is dead. It just proves that the deluded interpretation of it -- that you can buy stocks any time at any price and still do well -- is wrong. But it was always wrong. It just became easy to forget during the '90s bubble. For as long as people have been investing it's been true that if you pay too much for an asset, you won't do well in the long run. If you buy the S&P 500 at 30 or 40 times earnings, as people did in the late '90s, you're going to fail. If you do like Bill and wait until it's closer to its historic average of 15-20 times earnings (or even better, lower), you'll do all right. Nothing about the last decade has changed that. The '90s, not the 2000s, were the fluke.

Second, most people know that buy and hold means holding for a long time, like 10 or even 20 years ("Our favorite holding period is forever," says Warren Buffett.) But, in an odd mental twist, they use volatility measured in months or even weeks to reason that it doesn't work.

The market suffered all kinds of schizophrenic turns over the last decade. Since 2002, there have been 401 days of the Dow Jones (INDEX: ^DJI) rising or falling more than 1.5%, and 83 days of it going up or down more than 3%. These can be emotionally devastating for investors following daily market news, watching their wealth surge and crash before their eyes.

But Bill didn't even know about them. He was too busy enjoying his sanity at the beach. He knew he was investing for the long haul, and that he bought at a decent price. Why should he care what stocks do on a daily, monthly, or even yearly basis? While others tumbled through manias and panics, Bill's blissful ignorance was one of his greatest advantages -- as it is for most buy-and-hold investors.

Naysayers of buy-and-hold investing lose track of this to an almost comical degree. The "flash crash" of 2010 sent stocks plunging for 18 minutes before rebounding. Last week's snafu by market-maker Knight Capital caused a handful of companies to log some funny quotes for half an hour. These events should be utterly meaningless to long-term investors. Yet the number citing them as proof that buy and hold no longer works is astounding.

Jason Zweig of The Wall Street Journal quoted an investor last week dismayed with the Knight Capital fiasco. "You could buy and hold a company for 15 years and then have everything you've built up disappear in five minutes," he said. The same fear was echoed two years earlier during the Flash Crash.

Folks, accept some frank advice: If you measure your portfolio in five-minute intervals, you shouldn't be investing. If you think business value is "lost" by a few misquoted trades, you shouldn't be investing. Value is created when a business earns profit, allocates it wisely to its owners, and compounds year after year. An errant stock trade doesn't make a company less valuable any more than misplacing your birth certificate for 18 minutes makes you less alive.

"There's no such thing as a widows-and-orphans stock anymore," Zweig's investor complains.

Sure there is. Ask Bill.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

The article Buy and Hold: Still Alive and Well originally appeared on Fool.com.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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