Why Buy and Hold is Not a Winning Strategy

Before we get into a discussion of why Natural Selection investing works, it is important that investors understand what the strategies of their conventional financial planners provide for them (or more aptly, what they don’t provide). Investing in under-performing or bear market assets is one of the most common mistakes in the investment world and in conjunction with high management fees, is the leading cause of sub-standard returns for investors. Unfortunately, it is also the hallmark of buy and hold strategies employed by the financial services industry. Regardless of whether an investment is flat or losing money, we are told to wait it out. Of course, we are led to believe that this is perfectly normal and when under-performance occurs, we are told that our investments are long-term and therefore we should not worry because the returns will come in the future. In reality, the returns often never materialize.

 

The sad fact is that “buy and hold” exists simply because the financial services industry doesn’t get paid based on their market performance with your investment money. Rather they get paid based on the quantity of money that they hold under management. It is their goal, therefore, to keep clients fully invested regardless of market conditions. Unfortunately, there are large stretches of time where buy and hold has performed miserably because markets were in correction, and depending on your age and investment horizon, you could find yourself a victim of bad timing. For illustrative purposes, consider the following 20-year chart of the US S&P 500, which is an index of 500 large-cap companies in the US, a common benchmark that most professional money managers seek to outperform (usually unsuccessfully).

The total return for the S&P 500 for the 20-year period from 1998-2018 illustrated in this chart is 173%, which sounds great and is significantly better than Canada’s leading index, the TSX (140%). When one looks at the compounded annual rate of return (4.9%), it actually sounds much less impressive, especially when considering that the financial services industry charges investors annual fees that can be 2-3% or higher. 

 

This time period above was marked by two large corrections, one of approximately 50% between 2000 and 2003 and a second correction of 58% during the 2008 financial crisis. Imagine the pain you would feel if you were set to retire in 2003 or 2009 and saw half of your portfolio value disappear. Similarly, if you began investing in 2000, a full 13 years later, the index was still at the same level, meaning that you had basically wasted a full decade of investing. Worse yet, the index was down a full 58% between 2000 and 2009. The implications of losing this many investment years and this much capital cannot be overstated in the context of one’s total investment and retirement planning lifespan. As this chart clearly illustrates, adhering to the buy and hold mantra, your investment future becomes simply a matter of chance, which should be considered unacceptable for most individuals.

Now consider the same investment where a simple eight-period moving average was used as a signal to either buy or sell the S&P 500. The eight-period moving average is illustrated by the blue line on the chart below. In this case, we could say that if the index closes each period above the moving average, the investor remains invested. If the index closes below the moving average then the investor moves to cash.

If this is our investment criteria, we can see that the investor remained invested during most of the positive years and was able to sidestep both major declines. Investors needing to retire between 2000-2003 and 2007-2009 were spared catastrophic losses and investors with longer investment horizons were similarly ahead of those who bought and held through these crashes, or worse, those who sold at the very bottom. The total return during the same 20-year time period was 300%, which is significantly better than the buy and hold case (173%) and without the emotional stress associated with large losses. Additionally, it is evident that the S&P 500 has now been in a 10-year bull run and is quite possibly due for a market correction or bear market, which could once again crush the portfolios of “buy and holders”, like it did in both of the two previous bear markets.

In summary, if we look carefully at these charts we can see that in essence, what the investor has done with these simple buy and sell signals is invest in the positive trend and divest from the market when the trend is about to end.  Although this is an extremely basic example meant to illustrate the merits of market timing, I am suggesting that trend trading when used in conjunction with my Natural Selection approach, can be applied across multiple ETFs and stocks to produce a high performing, low risk, low cost portfolio. To understand this process more fully, let’s dig a little deeper into what trend trading really means and how we can use certain indicators as a basis for what to hold in our portfolios.   NEXT

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