The Myth Of Buy And Hold

November 13, 2007 at 12:51 pm  ·  Category: Business and Investment Philosophy

“If you have a good gain in your stock and it has become fully valued based on your analysis, then take your gains and look for another strong company to invest in.”

– Brent Wilsey, Wilsey Asset Management, “Buy and hold technique as obsolete as Polaroid camera”, San Diego Daily Transcript, October 19, 2007

Everybody who starts to educate himself about investing is bombarded with the conventional wisdom of long term investing: Buy and Hold, You Can’t Beat The Market, etc….

It never ceases to amaze me how the conventional wisdom, which is so deeply entrenched and widely accepted, could be so wrong.

The financial planning and investment advisor industry is filled with professionals who simply buy a diversified set of index or mutual funds and hold forever.

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But why should stocks necessarily go up in the long run? 

This essentially amounts to a long term bet on the US or Global economy.  If you want to make that bet, sure.

But even if you believe in the long term future of the US and Global economies, it is a historical fact that growth goes in cycles of booms and busts. 

The short term is frequently rough going.  And by short term I don’t mean a couple weeks or a month.  Stocks regularly go down for periods of 2 or 3 years.  Those are called Bear Markets and they are a recurring part of the economic and investment landscape.

Let’s get concrete.  Let’s say you buy an actively managed growth stock mutual fund for $25.  18 months later it’s at $33 – up 33%. 

Isn’t it possible that the fund was a good value at $25 but not $33?

Or, to make the example even more concrete, let’s say you buy a stock at $15 because you think it’s cheap.  Say it has a forward P/E ratio of 10.  When the stock goes to $30 it’s not cheap anymore!  You were right, but now it’s time to get out.

What if you still like the company long term?  Why not sell it high and look to get back in at a better value?

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Two of the arguments against active management are: transaction costs and taxes.

The transaction costs argument doesn’t hold much water anymore when you can buy/sell an unlimted number of shares at a discount brokerage for $10.

The tax argument has some merit but would you rather pay 50% on a 50% gain or 20% on a 25% gain? 

The first works out to a net profit of 25%, the latter 20%.

Ultimately, I don’t think you can let tax considerations completely determine your trading as sometimes the most profitable option is to sell at a good price and pay a higher tax rate.

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This is nothing but the rankest common sense.

How did things get so confused?

As usual, the professors are at fault.

Back in the 1960s, a graduate student from The University of Chicago named Eugene Fama published his dissertation on the so called “Efficient Market Hypothesis”. 

This is the idea that security prices immediately and accurately embody any new information as buyers and sellers make trades.  It amounts to the claim that markets are rational and that the prices of securities accurately reflect all of the publicly available information.

If that were the case, it wouldn’t make sense to try and buy cheap stocks and sell expensive ones.  Because market prices accurately reflect all public information, stocks never get cheap or expensive.

In fact, it no longer becomes possible to outperform the market by having some kind of edge.  Everything is supposedly already “in” stock prices.  No edge is possible.

It is primarily on this foundation that index funds and the whole religion of buy and hold stand

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Now ask yourself this question: do securities markets strike you as models of rationality? 

Or do they strike you as arenas where human emotions and frailties, things such as fear, greed, overconfidence, ignorance, ideology and doubt, for which the academics’ mathematical models have no room, are in play?

Nobody of the slightest common sense would hesitate in answering the latter. 

And there, dear friends, is the refutation of the myth of buy and hold.

Posted by Greg Feirman  ·  Trackback URL  ·  Link
 

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