Is Buy and Hold Dead?

Recently, I picked up a book titled “Buy and Hold is Still Dead” by Kenneth R. Solow. Even though I am very much a Warren Buffett style investor who believes in the buy and hold strategy, I was curious as to what this contrarian author had to say.

When I first started reading the book, I was obviously sceptical that it would have meaningful insights to really rule out the buy and hold strategy. But to my surprise, I actually agreed with some of the things said in that book.

In the book, Solow said that he believed investors should actively manage their portfolios by looking at stock market valuations instead of merely buying and holding (at whatever price). He cited examples where market valuations had run ahead of company earnings and buying stocks or holding them led to poor returns. These included buying stocks before the 1987 Black Monday or the 1999 dot com boom.

He also believes that investors can actively manage their portfolio allocation to stocks and other assets better than simply buying and holding. When price-to-earnings multiples are high, he advocates shifting money away from stocks into other asset classes, and vice versa. This makes some sense to me, but I do realise there are also pitfalls and limitations to this strategy. With that said, here are some of my thoughts on active portfolio management versus the buy and hold strategy.

Active portfolio management

The active portfolio management works for investors who are consistently monitoring share prices. They need to see if their current stock portfolio prices have outrun their earnings growth and, if so, reduce their exposure to stocks.

There are a few benefits to this method of portfolio management. For one, investors can avoid heartache if a stock market correction occurs. At the same time, if their portfolio consists of cash during a bear market, they have the financial power to buy stocks on the cheap, when valuations are much lower. This is more useful for investors who invest in ETFs as they can simply add or reduce their ETF holdings.

However, there are a few limitations to this strategy. Foremost, investors who manage their own stock portfolio and have multiple stocks in their portfolio end up having to monitor each stock position, which is most certainly a time-gruelling process.

There is also the problem of additional transaction fees that can eat into returns. Poor timing of reallocating your money may also lead to reduced returns. In addition, investors tend to wait too long before buying back stocks after a bear market, partly because of fear and not knowing when the stocks have bottomed out.

In the words of John Maynard Keynes, “Markets can remain irrationally priced for longer than you can remain solvent”. With markets so irrational, it can be difficult to get the timing of reallocating your portfolio right.

Buy and hold strategy

The buy and hold strategy, which is advocated by Warren Buffett, is to buy great companies at good prices. This strategy is much simpler to execute as investors search for strong companies and ensure they make their purchases at reasonable prices, before waiting for the stocks’ valuation multiples to grow. With higher multiples, the stock prices should rise as well.

Yes, it is possible that stock prices can outpace earnings growth in periods of optimism, but “buy and hold” advocates believe that over a ten or even twenty-year period, the value of these companies will still be far greater over the long-term.

Buy and hold investors, therefore, take a hands-off approach and simply ride out the volatility of a stock believing that in the long-term, the stock price will be much more than what they have bought it for. This is assuming, of course, that they had bought a good company at a good price.

In fact, research has found that if you had invested in the Straits Times Index (SGX: ^STI) over any twenty year period between 1992 and 2016, you would never have made a loss. Likewise, between 1871 and 2002, an investor who has invested in the US stock market as a whole would never have made a loss.

The main pitfall of this style of investing is that in bear markets, investors who are heavily weighted on stocks will feel the pinch. If they did not allocate more of their portfolio to cash during the run-up before, they would be left with little opportunity to take advantage of the depressed prices.

On the flip side, buy and hold strategy has proven to be largely effective if executed correctly. The benefits include lower transaction fees, fewer timing mistakes than active portfolio management, and less need for investors to constantly monitor their portfolio. This makes investing simpler and often more financially rewarding.

The Foolish bottom line

As retail investors, there is no right or wrong method of investing. If you feel that you have a good grasp of valuations and know when to re-allocate your portfolio, then active management may be the best option for you. On the other hand, investors who want lower transaction fees, have high conviction stocks in their portfolio and prefer not to worry about short-term volatility, should use the buy-and-hold strategy.

For me, I am more inclined towards the buy and hold strategy. The only time I sell a stock is when stock prices have over-run their earnings capacity by a large amount due to over-optimism or when my investment thesis on a good company has changed. If stocks are just a little pricey, I am inclined to continue to hold on to them and wait out the short-term volatility. As such, you can say that I prefer to follow the words of Warren Buffett, “Doing nothing is often the right thing to do.”

Worried about the overall state of the market? Do you know the 1 thing you should never do in the stock market? The Motley Fool Singapore's new e-book lays out a plan to handle market crashes, details the greatest advantage you have as an investor, and looks at decades worth of market data to bring you the smartest insights on investing. You can download the full e-book FREE of charge--Simply click here now to claim your copy.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Jeremy Chia doesn’t own shares in any companies mentioned.