Passive And Buy-And-Hold Investing Doesn’t Work Unless...

General Considerations

For example, after the market crash of 2008 it seemed like buy-and-hold bashers came out of the woodwork.These nonbelievers were gleefully pointing to the so-called lost decade to validate their thesis that buy-and-hold was a dumb move. In this era of day trading mania where investors are more inclined to own a common stock for mere minutes rather than years, many pundits and investors alike jumped on the anti-buy-and-hold bandwagon.

One critical point that I want to clearly establish is that buy-and-hold is an investing strategy. Investing strategies, by definition, imply a long holding period. Speculation, on the other hand, implies shorter time frames where the speculator is attempting to exploit an arbitrage situation. My point is not to debate the virtues of one over the other, my desire is to point out that investing and speculating are not the same thing.

As an investing strategy, there is an “old” adage that supports the virtue of being a buy-and-hold investor: “a portfolio is like a bar of soap, the more you handle it the smaller it gets.” The true investor is looking for a place where they can allocate their capital in order to receive an attractive return on their capital at appropriate levels of risk. The higher the return they attempt to achieve, the higher the risk they’re willing to take, and vice versa.

Another general comment to be made about buy-and-hold as an investment strategy refers to investors who are looking to generate income from their investments. Income investors have the option of either fixed income, i.e., bonds, annuities and CDs, etc.; or income producing equities, i.e., real estate, dividend paying common stocks, etc. Of course, they can invest in these asset classes separately or in packages like mutual funds, MLPs, REITS or ETFs, etc. These investments need to be owned for long periods of time if any meaningful harvesting of interest or dividends is to occur.

The many faces of buy-and-hold

With the remainder of this article I will look at situations where buy-and-hold is a great strategy as well as situations where it’s not. For the sake of efficiency, I will present these discussions in graphic form through the lens of the FAST Graphs research tool.

Overvaluation caused the lost decade

The following FAST Graphs on the S&P 500 show the importance of valuation regarding a buy-and-hold strategy. The first graph plots the S&P 500 stock price correlated to earnings for the period calendar year 2000 through 2009 and the corresponding performance over this time frame. There are two important takeaways from this graph:

  1. Earnings growth for the S&P 500 over this time period was exceptionally low at 1.73% per annum.
  2. For the initial starting/year (ending December 31, 1999), the P/E ratio of 28.43 is at a premium relative to the historical fair value reference S&P 500 P/E ratio of 15 indicating excessive overvaluation.

Therefore, it should be clear that the so-called “lost decade” spanning calendar year 2000 through 2009 resulted from the combination of excessive starting valuation coupled with virtually no growth. As a result, investors foolish enough to invest in an S&P 500 index fund at the excessive valuation at the beginning of calendar year 2000 would have seen 10 consecutive years of negative returns (-1.1%) and this included dividend income. In other words, passive investing only works if prudent investors focus on sound valuation and growth potential in the same manner they would when choosing an individual stock.

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Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit ...

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