Five Big Flaws of Buy and Hold

Buy and hold is the predominate strategy for investing, preached by the industry especially when markets go down.  It’s much easier to buy and hold when things are going up and your way.

Although I understand the merits of buying and holding, I also think there are some important flaws with this practice:

1.    It ignores one of the fundamental strategies to making money.

It is tough for anyone to dispute that buy low, sell high is the one strategy that is guaranteed to make you money in investing.  The problem with buy and hold is it can ignore one key component to making money – the sell.  How can you make money if you never sell?  And if you do not have a strategy to sell, then it is possible your success comes from chance.  What if you need your money when the markets are down? Selling is a key component to making money.  You can’t ignore it.  How can you make money without selling?  The key then is to develop a sell strategy which is just as important as the buy strategy.  Most of the investment information out there is on how to buy as opposed to how to sell.

2.    You shouldn’t buy and hold crap.

Think about it.  If you buy crap and hold crap, what will you always have?  The one thing you do not want in your portfolio.  In other words, don’t buy and hold just for sake of buy and hold.  Think about what you own before you hold.  So how do you avoid crap?  There’s only one way to avoid crap and that’s called research.  Buying quality and holding quality makes some sense to me but how would you know if an investment is quality or crap without some research? Buy and hold is it only works if you pick decent investments.

3.    Buy and hold is hard to do.

Many experts will show you a mountain of charts with the ups and downs of the market.  They will tell you that markets go up about 70% of the time and down 30% of the time.  So if you just get through the bad times, you will eventually get to the good times.  I get it and I can appreciate the message of diversify and hold but at the same time, people’s emotions get in the way of buy and hold.  Instinct says that you are willing to hang on as long as things are going your way and you are making money.  But when times get tough it’s hard for people to hang on because instinct says ‘bail ship!”

The biggest hurdle to a successful buy and hold strategy is emotion or something I call the psychology of investing.  We, as emotional investors, can’t help but buy high and sell low which is the opposite of what it takes to make money.  Why is that?  It’s called ‘linear extrapolation’ which simply means we can’t help but think in straight lines.  When something is going up, we think it will continue to go up.  And when something is going down, we can’t help but think it will continue to go down.  As a result, we tend to chase winners and get rid of losers which is the opposite of buy low sell high.

4.    Buy and hold does not work in retirement.

Retirement is supposed to be the best years of your life.  If successful, that should mean shifting your investment focus from being a saver to a spender.  What is important to recognize is becoming a spender means that you will likely draw an income from your retirement savings.  This means that holding onto your investments can actually work against you.  It’s all about the math.  If you continue to take money out of mutual funds or stocks as markets go down, you may find that can have a devastating effect on the longevity of your portfolio.  Buy and hold is a viable strategy when investing FOR retirement but may not be a great strategy when investing IN retirement.

5.    Buy and hold creates complacency.

In a recent article in Investment Executive, a survey by the Bank of Montreal shows that 70% of people have no idea what they are invested in.  That’s a pretty sad statistic.  How much of that has to do with the fact that people are taught to buy something and forget about it for 10 to 20 years?  How smart is that?  My philosophy is different . . . No one cares about your money more than you care about your money.  It’s time to care.  It’s time to engage in your financial affairs.  It’s time to engage in your portfolio and understand that buy and hold does not always work.  Remember, buy and hold does not mean ignore.

So as you can see, buy and hold, although it appears to be the universally accepted strategy needs some caution.  Don’t be buying and holding just for the sake of holding.  Great investors have some strategy to sell.

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace. For more information you can follow him on Twitter @JimYih or visit his other websites Retire Happy Blog, Group Benefits Online and Advisor Think Box.

21 Responses to Five Big Flaws of Buy and Hold

  1. These are some really great points and if nothing else should motivate people to care more about their investments. Taking blind advice to buy and hold can definitely be dangerous!

    The only problem I see is that newbies learning about investing and attempting to do research can also be very dangerous because they don’t really know what they are doing. Buy and hold might be better for them than making big investment mistakes based on their own research.

    What approach do you recommend for the financially illiterate who don’t want to spend a lot of time managing their finances but also want to avoid buy and hold?

    • What a great point!

      My recommendation for financial illiteracy is to read more and ask more questions.

      In terms of investing, I think it is important to have a rebalancing mechanism in place whether it is done manually or automatically.

      Also, I am not opposed to buy and hold if you buy good quality investments. But as I said, you still have to monitor good investments from time to time because things can change.

      Thanks again for the comments and question.
      Jim

  2. I’ve spent the last nine years of my life exploring the flaws of Buy-and-Hold. My view is that this is the purest and most dangerous Get Rich Quick scheme ever concocted by the mind of man (I don’t say that it was designed to be this — only that this is in an objective sense what it is). I could write a book listing 500 big flaws of Buy-and-Hold (and am in the process of doing so!).

    The single biggest problem is one that Jim makes reference to when he says that investors should rebalance. Many have come to believe that rebalancing addresses the need to lower one’s allocation in response to overvaluation. It does not. Say that the risk level of stocks is a 2 when prices are fair and a 10 when we are at the insane level of overvaluation we saw in the late 1990s. The investor who rebalances remains at the same stock allocation even though it is far, far, far more risky at the higher valuations levels. And he doesn’t even know that he is doing anything wrong!

    The proper response to insane overvaluation is to LOWER your stock allocation. If you thought a 70 percent stock allocation made sense when prices were fair, a 10 percent stock allocation might make sense when we get to the sorts of price levels that have applied from 1996 forward.

    The aim should be not to keep your stock allocation constant but to keep your risk level constant. To do that, you must be willing to change your stock allocation in response to big valuation shifts (that is, to disdain Buy-and-Hold Investing).

    Great topic! We need to have more discussion of this, in my view.

    Rob

    • Hey Rob, Thanks for voicing your passion. You make some great points. In changing your stock allocation, are you referring to a form of “TACTICAL ASSET ALLOCATION”

      The benefit of conventional rebalancing is it takes the guesswork out of when markets are over valued or undervalued. What if you are wrong in your guess? How much risk is there in being wrong?

  3. are you referring to a form of “TACTICAL ASSET ALLOCATION”

    Thanks for your openness to new ideas, Jim.

    Tactical Asset Allocation is what lots of people call it. My view is that changing your allocation in response to valuations is not tactical but STRATEGIC — your choice as to when to change your allocation is of fundamental importance to the long-term success of your plan, in my assessment. I think that getting your allocation right is the single most important thing in investing and I don’t think there can ever be one allocation that is right at all price levels (because valuations affect long-term returns and thus cause risk levels to vary).

    The benefit of conventional rebalancing is it takes the guesswork out of when markets are over valued or undervalued. What if you are wrong in your guess? How much risk is there in being wrong?

    That question gets to the heart of the controversy over this idea (I call my approach [it follows from Shiller’s research] “Valuation-Informed Indexing”). You are right that rebalancing takes the guesswork out of it. But it also takes the thought out of it! You could be going with a wildly wrong allocation and not even know it because you never stopped to think through how much conditions had changed with a big shift in valuations.

    My approach to figuring out the best allocation is using a regression analysis of the historical stock-return data to identify the most likely 10-year return for stocks (I have a calculator at my site that does this). For example, in 2000 the most likely annualized 10-year return was a negative 1 percent real (in contrast, the most likely annualized 10-year return at the prices that applied in 1982 was 15 percent real). TIPS were paying 4 percent real in 2000. So for each dollar you put in stocks at that time you were likely giving up 5 points of return every year for 10 years running. Plus all of the compounding on that money in all the years following!

    Here’s a link to a study posted just last Friday that shows that Valuation-Informed Indexing beat Buy-and-Hold in 102 of 110 30-year periods:

    http://wpfau.blogspot.com/2011/01/valuation-informed-indexing-preliminary.html

    The thing that throws people is that this does NOT work in a year or two or three. The Buy-and-Holders are right that short-term timing does not work; there are many studies showing this. Do you know how many studies show that long-term timing does not work? There’s never been one! There are instead scores of studies showing that it ALWAYS works; that’s been so for as far back as we have records.

    Our entire economic crisis was caused by our failure in the 1960s and 1970s to understand the importance of the distinction between short-term and long-term timing. This became apparent only with the publication of research by Robert Shiller (author of “Irrational Exuberance”) in 1981. And there was little interest in pursuing Shiller’s ideas prior to the 2008 stock crash. So we went with Buy-and-Hold and, because Buy-and-Hold told us that there was no need to lower our allocations, we permitted stocks to become overvaluation by $12 trillion in 2000. Reversion to the Mean has caused $12 trillion in spending power to disappear from our consumer economy. There’s your economic crisis!

    This isn’t guessing. Short-term timing is guessing. This is taking price into account when buying stocks. It is impossible that there could be an asset class re which price made no difference to the long-term value proposition; stocks are no exception. So this always works.

    I don’t mean that by looking at valuations we can know precisely what the long-term return will be. There is always some element of randomness (at 20 years out, that element drops to 22 percent — So close to four-fifths of the risk of stock investing has been eliminated!). But we can today know the range of possible 10-year outcomes that follow from investing in an index fund at any of the possible price levels and the rough probabilities for the return ultimately obtained being at any of the various points on the range of possibilities.

    Is it possible to mess up with this? Yes. If you take extreme positions, you will mess up. But there’s no need to do that. Those who want to be cautious can use it only when valuations are at extreme levels and the odds of this working well are the greatest.

    People shouldn’t think that they are escaping the possibility of a mess-up by going with Buy-and-Hold. People are not aware that they are going with extreme positions when they follow a Buy-and-Hold strategy. But if Shiller is right, they often are. An investor who went with a 50 percent stock allocation both in 1982 and in 2000 was going with an extremely low allocation for someone with a normal risk tolerance in 1982 and with an extremely high allocation for someone with a normal risk tolerance in 2000, according to the historical data.

    There is no neutral ground when it comes to setting your stock allocation if valuations truly do affect long-term returns. Buy-and-Hold posits that there is. I view this as a dangerous and costly illusion.

    Rob

    • Rob, you don’t just comment. you’ve got enough here for an entire post!

      Thanks for sharing. I am interested in seeing your research.

      I still believe there is a place for simple conventional re-balancing as a strategy to enhance returns over straight buy and hold. Sometimes, simple is better but I am always open to new thoughts and ideas?

  4. I still believe there is a place for simple conventional re-balancing as a strategy to enhance returns over straight buy and hold.

    There are millions of smart and good people who strongly agree, Jim. All reading these words need to know that Rob Bennett has been wrong before and it is entirely possible that he is wrong again this time. That goes no matter how many words he puts forward in support of his case.

    Thanks for the good back and forth. It makes me happy to see it because that’s what I think helps people the most. When people hear both sides, it forces them to think and that way we all gradually move forward over time.

    Rob

    • Thanks for that last comment. I’ve often said it’s not about right or wrong but rather what’s right or wrong FOR ME.

      Money and investing is personal. That’s why there is no ONE way to do things. People need to educate themselves, think for themselves and then make good decisions for themselves.

      so to re-iterate the words of a smart man . . .

      Thanks for the good back and forth. It makes me happy to see it because that’s what I think helps people the most. When people hear both sides, it forces them to think and that way we all gradually move forward over time.

      Cheers!
      Jim

  5. Hi Jim thanks again for another interesting read. I have to agree that it is up to each individual to do their research extensively as investments are a huge deal. It’s your hard earned money at ‘stake’ and why wouldn’t anyone research more, why would someone just invest and forget? You have brought up some interesting points that have me researching my own investments. Thanks!

  6. It’s true that many people can’t stick to a buy and hold strategy unless they buy, hold, and forget. However the fact that a strategy is difficult to execute through the full cycle doesn’t mean that it’s not valid. That’s a good thing since no investment strategy can do well if everyone follows it.

    It’s certainly something to consider with any strategy. For example if your plan is to invest in the top managers but every January you switch to last year’s top performer you aren’t following that strategy well either.

    • I agree! I’m not saying buy and hold is bad. I’m just saying it’s not without some flaws. Too many people blindly follow this strategy without thinking. Think it through. If it still makes sense then great.

  7. When investing, there are no black and white strategies in my opinion. Each approach can be tweaked for maximized return. Having said that, investors need to be familiar with their playground in order to succeed.

    • I agree BTI. There is no single strategy that is applicable to everyone … including buy and hold. Because Buy and Hold is so commonly preached, I just want to make sure people don’t blindly follow the strategy. Buy and hold definitely has it’s place.

  8. The simple fact is, 97% of people who buy and sell using ANY strategy, including those espoused here, do not beat buying and holding the index over long periods of time. I know it, and I’m sure most people reading here know it. The fact that you don’t beat the index doesn’t change no matter what lipstick you put on it.

    1) Selling is not a good idea, not in the long term. Active traders do not outperform the index over the long term. They don’t. It sounds good. It doesn’t work.
    2) Buy and hold crap? What? This sounds ‘nice’. But what really has to happen is that you would need to buy and hold only investments that increase in value, not some poorly defined ‘crap’. And once again, statistics have shown that researchers don’t beat the index over the long term. No matter how smart their system is. All the mutual fund companies out there can’t do it, now an individual investor is going to figure this out?
    3) that’s human nature. I’m able to do it. If you don’t have the discipline to stick to buy and hold, you don’t have the discipline to stick to anything. This isn’t a valid criticism of buy and hold. It’s a feel good sales job.
    4) Buy and hold doesn’t work in retirment? No facts to back up that one. Retirement timelines these days are in the range of 30 years. If that’s not a long term invesment timeline I don’t know what is. Retirement is absolutely a time to consider using long term investment strategies.
    5) Buy and hold creates complacency? I don’t even know what that means.

    Nothing in this article is backed up with facts. It’s all feel good stuff that sounds like it came from a mutual funds sales guide.

    • Hi Glenn, Thanks for your strong opinions! People need to hear other sides of every story to make better decisions.

      I am not advocating an active trading strategy. I don;t practice that myself and I do not believe in market timing. My message is very simple…engage in your portfolio and do not just buy and hold for sake of buy and hold.

      Having been in this industry for 20 years I believe buy and hold is the predominate strategy preached by the investment industry but that strategy has flaws.

      I’m not saying that buy and hold does not have merit and a place but I do think buy and hold does not mean ignore which is what too many investors do.

      I also believe re balancing is a critical strategy for success based on facts – http://retirehappyblog.ca/more-on-the-art-and-science-of-re/

      Some people think re-balancing is a form of buy and hold but others don’t. Personally, I don’t care how you define it. Just manage your portfolio.

      It sounds like you engage in your portfolio and are aware of what you have. Don’t take my comments personally. My hope is this article will help some people manage their portfolios.

      Jim

      • Jim, I once asked a prominent actuary/researcher about rebalancing. I asked him why I would take money from strong performing investments and put them in weaker performing investments.

        His response was “Good questions”.

  9. In Holland, the generation of my parents kept Royal Dutch for 10th of years, even much longer, without touching it. The stock payed a healthy dividend, slightly more than a saving account. The increase in value was regarded as a bonus. Even in the non-performing markets of the 60′ and 70′, when the stock exchange index did little, they defended their Royal Dutch holdings if it where their castle.
    Younger generations where more greedy, and the 80’and 90’offered 7 to 8% in real estate. They didn’t liked the volatility of stocks.

    Now with asset bubbles around in real estate and gold it seems to me that Royal Dutch investors, happy with the relative high dividends are still doing fine. Timing the markets is extremely difficult and demands knowledge most investors, with their everyday jobs, just lack.

    The really different alternative these days, apart from speculative investments are hedge funds.
    Made a selection of several top performing hedge funds, mostly with automatic program trading, which over the last 10 years, on average made 20%. That’s the real game changer when it comes to long term investing and it the main reason why pension funds have increased there hedge fund investing activities substantially .

  10. Awesome points against Buy and Hold. It’s so commonly preached that people forget to do their due diligence on the Buy and Hold strategy itself. Buy and Hold has its place, but do you see a more effective strategy these days? Do you believe in trend following?

  11. Very well crafted article that points out some of the pitfalls of cruise control. This proves once again there are no absolutes in investing or in anything for that matter. Attention to detail and changes circumstances would seem to be essential here. This article was real eye opener for me and has refined my thinking in this area. Thanks so much.

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