Sunday, February 15, 2009

Buy and Hold Investing

I have been reviewing the credibility of the case for the Buy and Hold for the Long Term approach to investing.

As I understand it, the thesis goes something like this. No one can consistently forecast the stock market so it can only be viewed as a series of random events. The exception is that the market history supports the view that the markets always recover from a bear market. Therefore, if one buys "good stocks" and holds for the long-term, then the investor will eventually receive a good return on the market investments. The trick is to ignore market flucuations no matter how deep or how prolonged they may be.

This investment philosophy can be combined with dollar-cost-averaging, which is also based on the belief that it is impossible to time the market. One buys market equities/funds, say every month with a fixed sum. In that the prices fluctuate one buys more at lower prices and less at higher values.

There is no question, as long the country remains in business the index will come back eventually and surpass the pre-bear high. And, dollar-cost-averaging ensures that for prolonged bear markets one will be buying some shares at lower prices.

The whole think hinges, in part, on not picking stocks that never recover from the bear market and unfortunately that does happen. An index fund will eliminate that risk. But there is another little known risk. Unfortunately, the Buy and Hold approach only looks attractive if one "models it" using carefully selected portions of stock market history. In other words with good "market timing".

There have been periods of time when the market would have tested the patience of anyone subscribing to the buy and hold approach. The periods of market history I refer to are the 1929-1954 and the 1968 to 1982 time periods. The markets, as defined by the DIA Index, took 25 years to recover after the 1929 crash. And, the ~1968 to 1982 time period although a less severe bear in terms of depth (-45 % compared to the -89 % loss of 1929) but it was a time period where the market went sideways for about 15 years.

It is easy to show that for these two time periods, a lump sum, that was invested at the pre-bear peak, would have performed much better had it been in a nominal rate GIC. The green lines on the graph of the DJIA show a few recovery times, including the two mentioned above.

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