By Chuck LeBeau, Director of Quantitative Research, SmartStops.net
Investors are taught from day one that investing is all about taking calculated risks for an anticipated reward. The way investing is supposed to work is that the greater the risk the greater the reward should be.
Somehow the advocates of Buy and Hold as an exit strategy have lost sight of this primary principal of investing. In fact, Buy and Hold should not be evaluated as an exit strategy because it is in fact the absence of an exit strategy. All stocks are bought with the intent of selling them at some point in the future. There is no benefit to owning stocks that are never sold unless the intent is to harvest the dividends forever which is impossible since most of us do not plan on living that long. (By the way, there were $22 billion in dividend cuts just this last quarter.)
Buy and Hold is inherently flawed because it does nothing to define, limit or control risk. I am continuously amazed at the great lengths investors and some well intentioned academics will resort to in vain attempts to solve the risk problem rather than simply acknowledging that Buy and Hold is hopelessly flawed and can’t be saved even with extreme measures. The risk of Buy and Hold is undefined and unlimited. Therefore to any investor with a grain of common sense it is not an exit plan that should be relied on.
If we look at investments in the interest rate markets we will find that longer term instruments almost always pay higher returns than shorter term instruments. That’s because the longer you hold something the more risk exposure you have. No stock investment strategy (without leverage) could possibly have more risk than Buy and Hold. If you default to Buy and Hold you will find yourself in the market all the time risking everything. You would have to get very creative to take more risk than that but a few of our financial institutions have obviously figured out how to make the risk even greater and they have already suffered the consequences. These institutions are/were guided by professionals that should know better so it’s hard to fault mainstream investors who adopt Buy and Hold as the result of being told that it is the best way to invest. Unfortunately the advisers who promote Buy and Hold are typically compensated by assets under management rather than by performance.
I mentioned that many more sophisticated investors have gone to great lengths to try and fix Buy and Hold. First we have asset allocation models that contend that since Buy and Hold has unlimited risk you should avoid investing in stocks with most of your capital (even though the stock market offers more opportunity for large profits than alternative investments). Rather than invest a larger amount with some prudent limitation on risk these advisers say to reduce the risk by putting most of your capital some place safer. Of course this plan will reduce your returns. But if you had an exit strategy that was more intelligent than Buy and Hold it would be safe to place more money in the stock market and still have limited risk. Having more money in the market with limited risk should produce bigger and safer returns than having a small amount of money invested with unlimited risk.
Buy and Hold investors usually rely heavily on diversification to limit risk. Somehow the logic of having a basket of stocks with unlimited risk is deemed safer than having a handful of stocks with unlimited risk. Now that is a Pollyanna scenario if I ever saw one. We all have seen what can happen to a well diversified portfolio when the market tanks. It simply becomes a well diversified portfolio of big losers. By the way the advocates of diversification suggest that you rebalance your portfolio regularly (like that is going to help). In recent years a few ultra sophisticated money managers who use Buy and Hold have come up with VAR (Value At Risk) models to try and quantify the elusive risk of Buy and Hold. Just build a model based on a bunch of assumptions of what you expect to happen and you can estimate the risk of a Buy and Hold portfolio. That’s certainly the long and complex solution and has not proven to be helpful because what actually happens in the market is seldom correctly assumed.
To wind things up, let’s go back and take a final look at risk and reward. If we are to be guided by the principal that risk should be relative to reward then Buy and Hold should return the highest reward. Clearly the facts are that it doesn’t. Over the last ten years a Buy and Hold investment policy on the major indices would have yielded negative returns. What happened to our high returns for all that risk taken? Buy and Hold is no longer an appropriate plan to follow in today’s volatile markets. Find a more logical exit strategy that will limit your risk. There are plenty to choose from.