Why Buy and Hold Investing Can Never Work

A) The Dominant Model for Understanding How Stock Investing Works

 

The Buy-and-Hold Model for understanding stock investing is the dominant model of today. The lead advocate is John Bogle, founder of the Vanguard group of mutual funds. Other big-name advocates include: (1) William Bernstein, author of The Four Pillars of Investing; Larry Swedroe, author of The Only Guide to Winning Investing Strategy You’ll Ever Need, and Dallas Morning News Columnist Scott Burns. Money magazine has promoted Buy-and-Hold strategies aggressively since its founding in the mid-1970s. Even the U.S. Securities Commission has published materials suggesting a belief that Buy-and-Hold is a responsible investing strategy.

The history of the strategy can be traced back to the mid-1500s, when the idea of an “efficient” market first surfaced. University of Chicago Finance Professor Eugene Fama and others did extensive research supporting the model in the 1960s. Burton Malkiel then popularized the idea in his bestselling investing guide A Random Walk Down Wall Street, published in 1973. The runaway U.S. bull market of the 1980s and 1990s confirmed the merit of Buy-and-Hold in the minds of millions of middle-class investors.

There have always been doubters. Yale Professor Robert Shiller published research showing that valuations affect long-term returns (a finding in direct conflict with the idea that the market is “efficient” and thus sets prices properly) in 1981. Shiller’s book Irrational Exuberance (the subtitle is “The National Bestseller That Revolutionized the Way We Think About the Stock Market”) was published when tech stocks were crashing in early 2000 and received numerous positive reviews in highly regarded publications despite its rejection of the conventional investing wisdom of the time. Other thought leaders who have long expressed grave doubts regarding the merit of the Buy-and-Hold model include: (1) Cliff Asness; (2) Rob Arnott; (3) Ed Easterling; (4) Jeremy Grantham; (5) Andrew Smithers; (6) Peter Bernstein; and (7) John Walter Russell.

 

B) The Economic Crisis Raises Doubts

 

It was the stock crash and economic panic of late 2008, however, that ignited the fire that has led to more widespread and more sustained criticism of the long-dominant model for understanding how stock investing works. Justin Fox published The Myth of the Rational Market in June 2009. Rob Arnott declared in that year that the conventional investing wisdom of today is largely the product of “myth and urban legend.” Famed Value Investor Warren Buffett dismissed much of the thinking on which 90 percent of today’s “experts” base their strategic recommendations as “nutty.” And Peter Bernstein observed that, given the mountain of evidence that has accumulated over time that Buy-and-Hold simply does not stand up to scrutiny: “Everything has collapsed.”

In one sense, that is indeed so. There is no logical case that can be made in defense of the Buy-and-Hold concept today. Even its most adamant adherents have given up defending the model, as is evidenced by the Ban on Honest Posting that has been imposed at numerous investment discussion boards and blogs. There is another sense, however, in which Buy-and-Hold remains dominant. Investing experts have been highly reluctant to acknowledge the mistakes they have made in recent decades in clear and frank and plain and understandable terms. The result is that most middle-class investors continue to believe that Buy-and–Hold makes sense or even that it is the most prudent strategy available to them. Indeed, Fox argues that, while the Efficient Market Theory (the intellectual framework supporting Buy-and-Hold) has been discredited, the idea of sticking to the same stock allocation at all times remains a realistic strategy.

 

C) How Buy-and-Hold Became Popular

 

The key to making sense of this confused state of affairs is understanding where the Buy-and-Hold idea came from and why it once seemed to hold so much promise.

Throughout most of the history of investing knowledge, strategic analysis has been subjective and focused on short-term results. Those who favored stocks have been referred to as “bulls” and those who dissented have been referred to as “bears.” Both bulls and bears have of course always offered rationales for their beliefs. But until the 1970s it could not be said that the general public’s understanding of how to invest was scientific. That changed with the development of the Buy-and-Hold model. This model was rooted in academic research. Thus, its insights were not the product of subjective impressions — they were the product of objective testings of the historical stock-return data. Moreover, the then-new Buy-and-Hold model achieved a breakthrough in its focus on what works in stock investing not for a year or two or three but in the long term. Buy-and-Hold was in a number of important respects something new.

This was one key to the popularity it achieved in recent decades. The U.S. middle-class was at this time acquiring sufficient wealth to permit it to invest in stocks and employers were shifting the responsibility for the funding of their retirements to the workers, giving middle-class workers little choice but to learn something about equities. Most middle-class workers have long had a fear of investing in stocks because of the big losses associated with this asset class at times of stock crashes. The promise of a scientific, long-term approach held great appeal. Few middle-class workers studied Buy-and-Hold to the extent needed to understand where the ideas came from or why they were supposed to work. But most quickly grasped the essential point being promoted — this was responsible investing. Buy-and-Hold became popular because it was viewed as being a rejection of the Get Rich Quick thinking that had given much investment commentary a bad name.

A second reason why Buy-and-Hold won the confidence of millions is that its fundamental tenet is that markets work. Buy-and-Hold is Adam Smith Economics applied to the world of investing. Most middle-class workers feel no need to beat the market. Their aim is merely to earn their share of the rewards generated by the market. The slogans popularized by the Buy-and-Hold advocates — “It’s Not Timing the Market But Time In the Market That Matters,” “There’s No Such Thing As a Free Lunch,” “Stay the Course,” “Stock for the Long Run” — speak to an proudly practical and properly skeptical and generally optimistic people. The Buy-and-Hold marketing slogans hit emotional hot buttons (and for entirely good and encouraging reasons).

Finally, Buy-and-Hold became popular because of the low stock valuations that applied in the days when the middle-class was first learning about it via A Random Walk Down Wall Street and the marketing efforts of Bogle’s Vanguard Group. Stocks were selling at rock-bottom prices in the late 1970s and early 1980s. When stocks are selling at low prices, the most likely 10-year annualized return is 15 percent real. Buy-and-Hold did not cause the amazing returns experienced by stock investors from 1975 through 1995. But our knowledge of the effect of valuations on long-term returns was far less developed in those days and so Buy-and-Hold was often given credit for those returns. Stocks would have done well regardless of whether Buy-and-Hold had been developed or not, but, since Buy-and-Hold was the new thing and appeared to be an entirely plausible and prudent model for understanding how stock investing works, Buy-and-Hold got the credit in the minds of millions of middle-class investors.

 

D) The Greatest Mistake in the History of Personal Finance

 

It’s easy today to explain why Buy-and-Hold can never work. The root idea is preposterous (but not obviously so to those who have not yet seen through it — there are many smart and good people who possess a strong confidence in the concept). For Buy-and-Hold to work, valuations would have to have zero effect on long-term returns. Stocks would have to be the only asset class on the face of Planet Earth of which it could be said that the price paid for the asset has no effect on the value proposition provided. This cannot be. Price must matter. And if price matters, investors should not be going with the same stock allocation at times when valuations are insanely high as they do when stocks are fairly priced or low priced. Buy-and-Hold defies common sense.

Why, then, did so many experts come to believe?

The academics responsible for the Buy-and-Hold concept discovered something of critical importance in their studies of the historical data. They learned that short-term timing does not work. That is, those who predict where stock prices will be in a year or two are no more successful than what would be expected if their predictions were random rather than informed by intelligent study of the market. This was breakthrough stuff. This changed the history of stock investing. No longer was stock investing about bulls and bears making guesses as to when to buy or sell stocks. The science of investing showed that short-term forecasting does not work and that a long-term focus is needed. The science appeared at the time to suggest that a Buy-and-Hold strategy (sticking to the same stock allocation at all times) makes sense.

The science did not prove that Buy-and-Hold works. The Greatest Mistake in the History of Personal Finance took place when the academics jumped to the hasty conclusion that the fact that short-term timing does not work necessarily leads to a conclusion that Buy-and-Hold is the only rational strategy.

There is not one possible explanation for why short-term timing does not work. There are two. The explanation adopted by Fama and the other academics was that short-term timing does not work because the market always set prices properly and it is therefore impossible for even the smartest individual investor to do a better job than the market at determining the proper price for stocks. There is an alternate explanation that offers every bit as satisfactory an explanation. It could be that the market does such a poor job of setting prices that there is no way for even the smartest investor to make sense of what the market is going to do. It could be that the reason why short-term timing does not work is not that the market is efficient but because it is wildly inefficient. It could be that stock prices do not reflect a rational collective assessment of the true value of stocks but an almost entirely emotional assessment that signifies just about nothing meaningful about the proper price of the stock market. Irrational markets cannot be timed because irrationality cannot be predicted.

There is a way to test which of the two explanations is the right one. If the market is efficient, the concept of overvaluation is silliness. An efficient market is a market that sets prices properly. But Shiller’s 1981 research (confirmed by a mountain of research done since then) shows that overvaluation is a meaningful concept. Shiller showed that stocks offer better long-term returns starting from times of fair or low prices than they do starting from times of insanely high prices. Even many Buy-and-Hold advocates acknowledge today that valuations matter. William Bernstein says that valuations affect long-term returns as a matter of “mathematical certitude.”

The further reality is that the market must in an ultimate sense be efficient. The purpose of a market is to set prices properly. If investor emotions were the sole influence on market prices, stock prices would go to the moon and stay there; what could ever persuade investors not to vote themselves raises by pushing stock prices higher and higher and higher yet? The market must ultimately be efficient, as the academics responsible for the Buy-and-Hold concept claimed. Yet the academic research of the past three decades shows conclusively that the market is not immediately efficient. What, then, is the full reality?

The full reality appears to be that the market is gradually efficient, not immediately efficient. It is investor emotions that determine market prices in the short term. But it is economic realities that determine stock prices in the long term (after the completion of 10 years of market gyrations or so). If the stock price rises too much higher than the price justified by the economic realities, opportunities open up for competing businesses to obtain the same assets on the cheap (relative to the market price assigned to them) and thereby to create a new business with the same profit potential as the overvalued one and thereby to pull the value assigned to it by the stock market down to reasonable levels. The market does indeed insure that stocks are priced properly. But it does not do this in an instant. The process can drag out for 10 years or even a bit longer.

 

E) Long-Term Market Timing Is Required

 

The strategic implications are earth-shaking. It turns out that we have been telling millions of middle-class investors precisely the opposite of what really works in stock investing. Since the market sets the price improperly in the short term and properly in the long term, successful long-term investing requires market timing (not the discredited approach of short-term timing, but long-term timing, which the historical data shows has always worked). The key to long-term success is to disdain the idea of sticking with the same stock allocation but instead always to be certain to adjust one’s stock allocation as required by changes in the valuations assigned to the broad market indexes (only one allocation change every 10 years is required on average but it is essential that long-term investors make this change — Buy-and-Hold never works in the long run because it argues that this change is not necessary or even that it is a good idea not to make the allocation change).

Consider the investor debating whether to buy the S&P Index or Treasury Inflation-Protected Securities (TIPS)  in January 2000. TIPS were paying a 10-year return of 4 percent real. The most likely annualized 10-year return on the S&P Index (according to a regression analysis of the historical data showing the effect of valuations on long-term returns) was a negative 1 percent real. That’s a difference of 5 percentage points of return for 10 years running. The investor with a portfolio of $100,000 was likely to lose 50 percent of that amount ($50,000) over the course of the next 10 years by following the advice of the Buy-and-Hold advocates to invest in stocks rather than TIPS “for the long run.” An investor with a portfolio of $500,000 was likely to pay a price of $250,000 for following the “expert” guidance. An investor with a portfolio of $1,000,000 was likely to be $500,000 less wealthy at the end of a decade as a result of his decision to place his confidence in the “scientific” approach to stock investing.

Tens of thousands of investing experts recommended Buy-and-Hold investing during the years of insane stock prices (January 1996 through September 2008). Millions of middle-class investors lost sums of $50,000 or $250,000 or $500,000 as a result. The combined effect is that we are in the process of seeing millions of failed retirements, millions of failed businesses and millions of failed marriages play out before our eyes. Buy-and-Hold has caused the greatest economic crisis since the Great Depression and we are still in the early years of our attempt to overcome this tsunami of financial mismanagement. Our political system is feeling the strain. Our misguided and arrogant advocacy of Buy-and-Hold has left millions of middle-class workers in a frightened and confused state and anger at the economic and political leaders on whose watch this epic disaster took place is steadily growing.

 

F) Rational Investing Is the Answer

 

We’ve got a huge mess on our hands. Fortunately, an inviting solution to the problem readily presents itself. Buy-and-Hold is rooted in a huge mistake. We have been urging people to invest their money pursuant to that mistake for many years now. What if we stopped?

If we stopped, we would be removing a ball and chain from the leg of the U.S. economy. We would be setting the U.S. economy free to achieve things it has never achieved before. We would no longer be misallocating resources to the tune of trillions of dollars. We would be freeing the market to allocate resources where they can do the most good, freeing middle-class workers to achieve financial freedom years sooner than was possible during the Buy-and-Hold Era, possibly freeing our economy of the threat of economic crisis for many decades to come (each of the four economic crises we have seen since 1900 was preceded by a time in which the Buy-and-Hold Idea [that stock prices do not matter] became insanely popular, popular enough to send stock prices to double their fair value [prices went to three times fair value in the late 1990s]). The Golden Age of Middle-Class Investing is awaiting us, if we are able to win the help of the few brave and civic-minded people of influence needed to usher it in.

 

G) A Wall of Resistance

 

There is one step required before the transition from the Buy-and-Hold Era to the Rational Investing Era (The Rational Investing Model is the alternative to the Buy-and-Hold Investing Model — it is described in some depth in articles and podcasts available at the www.PassionSaving.com site) can begin in earnest. We need to persuade the many experts who advocated Buy-and-Hold to acknowledge the mistake and to thereby launch a national debate on what really works in stock investing. As of today, an institutional interest in preserving the status quo and avoiding the need to acknowledge mistakes has worsened the economic crisis and threatened to bring on a Second Great Depression.

I put a post to a Motley Fool discussion board on May 13, 2002, noting that valuations affect long-term returns and that the studies that financial planners use to help us plan our retirements (which in deference to the Buy-and-Hold Model include no valuation adjustments) therefore get the numbers wildly wrong. Several big names in the field have confirmed my findings. For example, William Bernstein said that any aspiring retiree giving thought to making use of the conventional retirement studies to plan a retirement would be well-advised to “FuhGedaBouDit!” Swedroe said in a post to the Bogleheads.org board community that the conventional retirement studies (the Old School Safe-Withdrawal-Rate Studies) constitute “Garbage-In/Garbage-Out” research. I have led an effort on the internet for nearly eight years now to get these studies corrected and to bring to the attention of middle-class investors the flaws in the Buy-and-Hold Model responsible for the demonstrably false retirement claims which are likely to cause millions of failed retirements in days to come.

These efforts have been unsuccessful because of a wall of resistance put up by The Stock-Selling Industry to the idea of sharing with middle-class investors why Buy-and-Hold has failed and what the academic research of today says is most likely to work for the long-term investor. Two comments by Burns sum up the resistance that has been offered by many. In a June 2005 column, Burns explained why the media has failed to inform investors of what they need to know to protect themselves from the dangers of following a Buy-and-Hold strategy: “It’s information that most people don’t want to hear,” Burns explained. Investing experts see it as their job not to tell us what we need to hear about stocks but what we want to hear about stocks at times when we are insanely overinvested in them because of their earlier bad advice. In e-mail correspondence with me, Burns offered the view that my efforts to help middle-class investors learn the realities would prove to be “catastrophically unproductive,” presumably because they were at odds with the interests of The Stock-Selling Industry to keep the research findings of the past 30 years bottled up.

Bans on honest posting on the matters discussed in this Knol have been adopted at the discussion boards hosted at www.Morningtar.com, at www.IndexUniverse.com, at www.Bogleheads.com, at www.Fool.com and at a number of personal finance blogs (the Oblivious Investor blog, the Behavior Gap blog, and others). Numerous other blog owners (the owners of the Get Rich Slowly blog and the Frugal Dad blog, among others) have elected not to report on these matters after learning about them (while not banning honest posting in the comments sections of their blogs).

We are at an impasse. We know that Buy-and-Hold does not work. Even its most ardent advocates are so lacking in confidence in this model today that they insist on bans on discussion of its flaws at discussion boards or blogs at which they participate. But The Stock-Selling Industry feels strongly that it is not in its best interest to let the cat out of the bag. And most middle-class investors so lack confidence in their own ability to understand the realities of stock investing that they have placed their confidence in the very experts working hard to deny them access to what they need to know! One poster on the Vanguard Diehards board told me that all that I said about investing made sense to her but added that she did not have time to partake in a personal quest to discover “the Hold Grail of Investing” and thus felt compelled to invest her money according to what the many experts advocating Buy-and-Hold were telling her. Her number is in the millions.

 

H) A National Debate Is Needed

 

We need a national debate on what works in stock investing. Buy-and-Hold advocates should of course be part of that debate. Buy-and-Hold advocates are smart and good people and have developed many rich insights despite the mistake they made about the core Buy-and-Hold claim (that changing one’s stock allocation in response to big price changes is not necessary for long-term investing success). But we need a debate in which Buy-and-Hold advocates drop the pose of perfect understanding that has kept us from exploring new insights for so many years now. We need to see an openness to new investing ideas if our economic and political systems are to survive today’s crisis. We need to rebuild optimism for the future by partaking in a fresh start in our effort to discover how stock investing works, We need to put aside those of the old rules that no longer work and replace them with better-informed new rules that do.

I believe that it is going to take a populist uprising to get us there. My experience of the past eight years tells me that The Stock-Selling Industry is dead-set opposed to the idea of permitting middle-class investors to learn about the failure of the Buy-and-Hold Model. It is an industry’s dream to have millions of customers who have come to believe that there is no price at which its product does not offer a compelling value proposition. And this field is a field in which a perception of expertise is critical for success; acknowledging mistakes is viewed by most in this field as a career-limiting move. Most of today’s investing experts possess more expertise in salesmanship and in politics and in the construction of pointless word games than they do in how to invest effectively for the long run. Many have lost sight of the point of investing analysis — to help middle-class people finance their retirements. All this needs to change if our way of life is to survive the inevitable collapse of the Buy-and-Hold Model.

Our hope lies in coming to see the move from the Buy-and-Hold Investing Model to the Rational Investing Model (the Rational Model says that investors must consider price when setting their stock allocations) not as an investing question or an economics question but as a political question. We have a long tradition in this country of free speech. Free speech is permitted in our discussions of baseball and novels and nutrition and fashions. It should be permitted in discussions of the flaws of the Buy-and-Hold Model as well.

Once the internet is opened to honest posting on important investment topics, the Buy-and-Hold Era can quickly be brought to an end. There is obviously no one who obtains a benefit by investing ineffectively. So, if investors are permitted to learn about the realities as revealed by the academic research of the past three decades, the percentage of investors who understand that valuations affect long-term returns will gradually increase to the point at which Buy-and-Hold will no longer maintain enough support to be able to do further damage to the U.S. economy. I believe that all who have received benefits under the U.S. economic and political systems should be working hard to bring about that day as quickly as possible.

Buy-and-Hold can never work. But many of the insights developed by the smart and good people who brought us the Buy-and-Hold Model can do wonderful things to help millions when incorporated into a model that does work — the Rational Investing Model, a model that encourages investors to take valuations into consideration when setting their stock allocations.

 

I) Learning Together

 

 

January 2010

 

The Get Rich Slowly forum held two extensive discussions of the arguments put forward in this Google Knol in January 2010. The first focused on the question of whether Buy-and-Hold can work. The second focused on whether the promotion of Buy-and-Hold was the primary cause of the economic crisis.

I’ve recorded two podcasts that make the case for political action to open the internet up to honest posting on the flaws of the Buy-and-Hold Model. One is entitled Why Liberals Should Oppose the Continued Promotion of Buy-and-Hold Investing and the other is entitled Why Conservatives Should Oppose the Continued Promotion of Buy-and-Hold Investing.

 

February 2010

 

The Motley Fool (UK) Community examined this Google Knol in a discussion held in February 2010. A great point raised in that conversation is that this Knol discusses the problem with today’s investing advice but does not offer a detailed solution. I plan in coming days to put forward a Knol that will describe the Valuation-Informed Indexing strategy, which I believe is a more realistic strategy for those investors looking for a safe and effective long-term approach to stock investing.

The Wall Street Bear Discussion Board gives us the perspective of those who do not trust the conventional investing advice. The objection here is that I am naive to believe that any of the ideas developed by the Buy-and-Holders are even well-intentioned (I believe that Buy-and-Hold is gold except for the failure to account for valuations, which poisons everything).

Discussions started at the Hot Air and Free Republic sites, two conservative discussion-board communities, did not take off. There seemed to be skepticism in these communities about my intent in raising questions about Buy-and-Hold, although the grounds for the skepticism were not spelled out.

Steve Pavlina deleted a thread that generated some good discussion at his Personal Development for Smart People Forums. There was no abusiveness on the thread at all, just some good questions. I sent Pavlina an e-mail asking for an explanation for why the thread was deleted, but he did not respond.

I’ve been sending numerous e-mails about the flaws in the Buy-and-Hold model to journalists, bloggers, and investing experts and expect to send many more over the course of 2010. If you would like to read the full text of the e-mail sent to any particular person, please go to my blog (A Rich Life) and enter the name of the person into the search box; that will pull up the blog entry setting forth the text of that e-mail. E-mails have been sent to: (1) Vanguard Funds Group Founder John Bogle; (2) Keith Hennessey, Member of the Financial Crisis Inquiry Commission; (3) Yale Professor and Irrational Exuberance Author Robert Shiller; (4) Jonathan Curiel, Author of the True Slant Blog; (5) John Hayword, Author of the Doctor Zero Blog; (6) William Jacobson, Author of the Legal Insurrection Blog; (7) the HillBuzz.com Web Site; (8) Cassy FIano, Author of the Cassy Fiano Blog; (9) Jane Hamsher, Owner of the FireDogLake.com Site; (10) Washington Post Columnist E.J. Dionne; (11) New York Times Columnist Paul Krugman; (12) Patrick Courrielche, Journalist at www.BigHollywood.Breitbart.com; (13) Jason Zweig, Author of the Intelligent Investor Column in the Wall Street Journal; (14) Justin Fox, Author of The Myth of the Rational Market; (15) Bill Schultheis, Author of The New Coffeehouse Portfolio; (16) Dallas Morning News Columnist Scott Burns; (17) Former Wall Street Journal Columnist Jonathan Clements; (18) Money Magazine Editor Pat Regnier; (19) Maryland Financial Planner Michael Kitces; and (20) Jim Wiandt, Publisher of the www.IndexUniverse.com site.