Issues with Buy and Hold Strategies
If we stop here though and don’t go into the topic any further, the buy and hold strategy may win by default. If no other alternatives are considered, or if the ones that we are considering aren’t well understood, then we may indeed come to the conclusion that buy and hold is best or at least up there with anything else.
There’s also the issue of the time horizon shrinking, so if this was a good strategy at 30 years, when we’re down to 20 years, the thing may not perform so well. If we’re down to 10 or even 5, randomly holding may be no better than a crapshoot, and may put our hard-earned savings at serious risk as we approach the time that we will need the funds and can no longer ride out long bear markets or even short ones if the time is close enough.
We could even say that the logic of the buy and hold strategy simply doesn’t survive any sort of real scrutiny, for the following reason. If our entry is based upon us holding the investment for, say, 30 years, in order to be successful, because this time frame is dynamic, this will require us to re-assess things along the way. At some point, when the strategy is far from complete actually, the time remaining will not be sufficiently long to justify the strategy.
We know this at the outset though, and we end up with, we’ll hold it for 30 years but we cannot hold it for 30 years based upon the original idea because the original idea becomes invalid prior to the term of the investment.
It’s not hard at all to imagine this process. We invest $10,000 and expect to need the money in 30 years. 10 years goes by, and we know that 30 years from here the strategy presumably is valid, but we no longer have that long. We will instead have to come up with something that works for 20 years for us to have the proper focus.
We can’t really come up with a static strategy for 20 years either, and it really won’t be a random buy and hold approach because this is not enough time for that. Whatever we come up with though, if it does work for 20 years, we’re really not going to be able to validly stick with that either, because this time frame will shrink. We’ll have 10 years left for instance and need to change our strategy again, but this makes the 20-year strategy, and the 30-year one before it, both invalid because they had no chance to play out fully or even close to it.
While in this case we’re going to be investing for 30 years, we almost always will contribute to our investments over time. If we’re putting in money with 30 years to go, and we also are putting money in with 20 or 10 years left, we will no longer be able to rely on a strategy based upon 30 years left because the amount of time left gets shorter and shorter.
The Static and Arbitrary Approach to Long-Term Investing
This is actually a terrible strategy in spite of how popular it is, and the real problem with it isn’t the kind of returns that are often generated, but the amount of additional risk that we take on, usually without all that much consideration of this.
When your only plan to sell is when the calendar strikes a certain point, then this will leave you fully exposed to any and all risks that may emerge. Especially if you are investing in index funds, the chances of losing all of your money is extremely low, and this is also the case with any well diversified portfolio, but you’ll still be subject to whatever crashes or other events come along, with no recourse, by design.
The problem here is that we aren’t really judging the quality of our investments in any sort of dynamic manner, perhaps doing so at the outset but often not doing any analysis at all, apart from buying more of it without really thinking very much.
Things change though, and even though IBM for instance may have looked like a good stock 5 years ago, it’s lost half its value since then and during this precipitous decline it surely hasn’t been a very good performing investment.
If we just close our eyes though then we won’t really understand why this all matters, and some would say that we cannot ever know where stocks or other instruments are ever going, besides of course that they tend to go up over the very long term. Even with its sharp decline, IBM is still worth about 3 times as much as it was 30 years ago, so those who held it all this time are still up pretty nicely.
In this case, as we were approaching our 30-year limit, presuming that’s what our timeframe was, we would have to see it go from a 600% to a 300% return. Since we’re not using performance at all to judge this though, we’re forced to hang on and lose over this latest drop, and hang on even to the point where we end up with a negative return if things get bad enough. We may wonder why it ever makes sense to subject the managing of our investments to such an arbitrary condition as length of time to invest.
The market doesn’t care when we plan to retire for instance, and the realities are not in any way related to our situation other than the fact that we need to be more careful and manage risk more closely the less time we have. When we refuse to manage risk at all though, we just go from mismanaged to even more mismanaged as time goes on.
Seeking a More Dynamic Approach to Investing
The only real chance we have to come up with a plan that will remain valid is to use one that is not static, which means that how long we hold our investments will need to depend on other factors besides our overall time horizon. It is a bad idea entirely in fact to seek out conditions of our entering and especially staying in investments that aren’t really based upon the changing conditions of the market.
If we are putting our money into something, how it’s done in the past may be good to know, but this cannot ever trump how the investment actually does once we own it. In our example with IBM stock, we may have been happily holding it for years, but this should be only because it has merited this holding, not because we simply choose to ignore the performance of our investments.
Like a lot of securities, this stock has taken a pretty bumpy ride to where it is, including several distinct shows of both strength and weakness that both lasted several years and covered a lot of ground. Perhaps we really like this stock and perhaps when we invested in it originally its fundamentals looked great, but times change and we cannot simply refuse to notice and think that this is not acting foolishly because so many others do this.
This all is no less true whether we’re investing in a stock, a chosen basket of them, or broad stock indexes. Indexes, or the stock market itself, performs well at certain times and poorly at other times, and these things occur in cycles, cycles that aren’t so hidden or unpredictable as we may think.
In fact, as a general rule, the shorter the timeframe, the more difficult it is to predict where it is headed. Do we really know where the price of IBM stock will be in 30 years, if they are still in business? Do we know where the market will be that long out, given how much things could change over 30 years?
What we do instead is to see that it has gone up over the last 30 years and invest in it hoping that the past will be repeated well enough for our liking. There’s too much at stake here to just be hoping things work out based upon what happened in bygone days, and basing our future upon this.
There are many fund managers out there, most of them in fact, that cannot even beat the market, and they use a lot of both microeconomic and macroeconomic data to decide what to put their money in. If they can’t do it, with their vast resources and expertise, what chance do we have if we play a role in managing our investments?
As it turns out though, these funds are saddled with a huge handicap, and cannot manage market risk very well at all, due to their funds being committed to being long the market essentially at all times.
Market risk is the biggest risk out there by far, at least if you are well diversified, and it’s foolish not to be unless you have some serious skills, ones well beyond the typical investor. If we can’t be out of the market and even playing the other direction when we need to be, we will have no choice but to bear the full brunt of this risk.
If the stock market crashes and loses 75% of its value, the buy and hold investors will still be there, because their plan doesn’t address such things. They may be able to limit their losses by putting a certain percentage of their assets in bonds, but not being in the market when it is being hammered isn’t even in the conversation.
Being willing to ask the question of whether we should continue to hold our investments based upon their performance, which may mean that we may steer completely clear of markets or at least the long side of them at certain times, is the first step toward understanding how to manage your investments better.
Few even get to this stage but if we are thinking that there is only one option, to be invested and to be invested in just one direction at all times, we’ll just be subject to the same risks and problems as the crowd, most of whom have no idea what they are doing.