Five Reasons Why Buy-and-Hold is Dead

By Smita Sadana  JUN 26, 2009 11:37 AM

Why it's left a generation of investors shattered.


Wall Street, in true self-serving style, has harped on buy-and-hold mantra for decades. “Experts” have claimed there’s no reliable way to time the market, and you have to be fully invested at all times to benefit from the growth potential that equities offer in the long term.

Millions of Baby Boomers’ hopes of a decent retirement lie in ruins at the altar of this buy-and-hold concept. Is there a better way? That would be an interesting topic for further discussion (and I’m sure, debate) in an upcoming article. Here, I want to discuss 5 factors that, in my opinion, are contributing to the slow-but-sure demise of the buy-and-hold concept.

1. Easier access to brokers, cheaper commissions, and the rise of ETFs.

Do you remember calling a broker and placing a trade? Did you ever second-guess your intention while placing the trade? Thanks to fast access to the web that most of us have become accustomed to over the past several years, action often precedes thought. People frequently take longer to deliberate over a Chinese take-out menu than they do over placing a trade.

I often compare it to cash versus credit-card spending: Even though they’re substitutes for each other, they can have a different feel, and therefore instigate different behavior.

Furthermore, technology has dramatically driven down the cost of trading. Trading commissions aren’t considered to be a barrier to position entry or exit anymore. If a short-term opportunity crops up, investors don’t feel shy about taking action.

Furthermore, discount brokers did to full-service brokers what ETFs seem to be doing to their mutual-fund brethren. ETFs offer real-time pricing and instant liquidity, compared to the end-of-day pricing/liquidity of mutual funds. Forget long-term buy-and-hold -- many investors aren’t even willing to wait till the closing bell!

Ultimately, easier access to cheap trading opportunities led to infidelity to the buy-and-hold thought process.

2. Easier access to information and susceptibility to peer pressure.

Ubiquitous communication enabled by more efficient and cheaper networking technology has worked wonders in making the world a smaller place. But there’s also a dark side. Investors -- by being connected with the rest of the world -- have added to their financial-information biases. I define this as an access to overabundant financial information that’s seduced investors into believing they really know a great deal and can keep up with the ever-changing landscape. In reality, it’s generated more heat than light: Information is no substitute for knowledge or actionable insight.

Social-networking sites like Facebook, MySpace, and Twitter as well as thousands of blogs, have only increased the temptation factor, and has made the financial-information bias contagious!

The famous Asch Experiment “tries to show how perfectly normal human beings can be pressured into unusual behavior by authority figures, or by the consensus of opinion around them.”

In their book, Sway: The Irresistible Pull of Irrational Behavior, authors Ori Brafman and Rom Brafman say “regardless of how independent-minded and steadfast we may think we are, we are all tempted at times to align ourselves with a group. We may worry that if we voice an unpopular viewpoint others will doubt our intelligence, taste or competence”

Investors are swayed into frequent trading by this extreme connection to information and to others. Trading has become just another aspect of being accepted into a larger network; yet another way to keep up with the Joneses (or should I say, the Kardashians).

However, it’s important to note that in a stunning variation of this experiment, the Brafmans note that “although the sway of group conformity is incredibly strong, it depends on unanimity for its power.” If a dissenting voice (that of reason?) is introduced, the influence of peer pressure is markedly reduced.

That might explain why generally, investment clubs have a lower turnover and greater success in following a buy-and-hold strategy. In that respect, Minyanville’s exchange is a great way to voice that dissent.

3. The world's accelerating rate of change has created the perception of increased risk in buy-and-hold strategy.

Consider the following statistics:

Innovation is driving forward at an ever-increasing pace (the recent Business Week cover-story titled "Innovation Interrupted," notwithstanding). New businesses are getting created, even as legacy companies struggle to adapt to the changing paradigm. No business is safe: Even companies that had been historically viewed as stable are seeing their business models turned upside down. Netflix (NFLX) is making Blockbuster (BBI) irrelevant, Google (GOOG), Craigslist, and the Internet are pushing newspapers into extinction, and Amazon (AMZN) is giving traditional retailers a permanent headache.

Thanks to the web, the dissemination of knowledge is happening in record time. But that also means that consumers’ tastes, needs, and wants are changing at a record pace. Can we blame investors for not feeling comfortable committing to stocks of their favorite companies for the long term?

Take for instance, Crocs (CROX), which went public in 2006. As the word spread -- fueled by peer influence -- its sales and popularity grew. The stock quintupled in less than 2 years, rising from $14.27 to a high of $74.75. In the following 2 years -- as consumers moved on -- the stock price was cut by 95%. It’s currently trading at $3.57.

Many such examples abound in the tech sector. Take the case of Motorola (MOT). It was number-2 in the cell-phone business at the end of 2006 with a 23% market share on the back of the runaway success of the Razr. But it stumbled on the transition to 3G and Smartphones, and has now become a shadow of its former self. Similarly, Sun Microsystems (JAVA) was the "dot” in during the Internet era of the late ‘90s. It was recently sold to Oracle (ORCL) after a 95% drop in stock price.

This doesn’t mean there weren’t winners that would have richly rewarded buy-and-hold investors. The same technology trends that undercut existing companies’ business models also launch new success stories and are the successes of the future. Research in Motion (RIMM), Apple (AAPL), Amazon, and Google, to name a few, have given buy-and-hold investors plenty of reason to smile.

However, the rapid pace of change means that to stay competitive, companies must not only be innovative, but paranoid about the need to constantly reinvent themselves to stay in sync with the changing times. The risk is high, since plenty of research suggests that the success of a company, ironically, sows the seeds of its own eventual failure. Over time, successful companies become more inwardly focused. They concentrate on preserving the status quo that’s the source of their profits so as to launch a new future from inside the 4 walls (as opposed to allowing a competitor to do the honors). Consequently, for every Apple, there are many more Sun Microsystems.

This increasing pace of change creates another significant risk factor for the buy-and-hold investor.

4. Once beaten, twice shy: buy-and-hold versus “buy-and-forget.”

In reality, buy-and-hold was never intended to be pursued without any risk-management techniques. However, risk management hasn’t been the strong suit for Wall Street firms. Consequently, instead of marrying buy-and-hold with sensible risk-management strategies, many people interpreted (or unintentionally implemented) buy-and-hold as what I call a “buy-and-forget” strategy -- with disastrous results. The failure to adhere to stop-losses and implement basic money-management techniques has consequently led to a knee-jerk reaction against the buy-and-hold strategy itself. Losses in a few positions due to “stopless trading” (another term coined by yours truly) can make the investors nervous about holding anything longer-term.

Losses can also affect investing judgment. Many investors react by allowing themselves to be seduced into attempts to recoup losses by employing alien short-term strategies that go against the buy-and-hold mantra.

5. Loss of faith in the markets.

Elie Wiesel said: “The opposite of love is not hate, it's indifference. The opposite of art is not ugliness, it's indifference. The opposite of faith is not heresy, it's indifference. And the opposite of life is not death, it's indifference.”

This indifference might prove to be the ultimate nail in the buy-and-hold coffin. The trust of the Baby Boom Generation -- which has been at the forefront of the buy-and-hold genre of investing -- has been violated. These investors have now seen 2 of the most gut-wrenching bear markets with more than 50% decline in the broad market averages in the space of 8 years. Stocks have been decimated, value-plays have been annihilated, and previously solid companies have disappeared into the rubble of the credit crisis. Lack of faith kills the ability to trust the long term.

And the financial industry didn’t do itself any favors by continuing to harp on the benefits of the long-term. Its intention was to keep individual investors invested in securities through the unfolding storm, rather than park money safely away from equities until the storm blew over. People turned to their trusted financial advisors in the midst of the storm last year and received the same encouraging “buy for the long term” mantra -- and the advice to do so in supposed safe stocks like General Electric (GE). The pundits gave resounding buys at every local low since the bear market began in 2007. (This, incidentally, was the primary driving force behind my objective and comprehensive analysis on how bear markets end and evolve into new bull markets.)

As they saying goes, faith is like electricity: You can’t see it, but you can see the light. Similarly, lack of faith in the markets transpired in investors distrusting the buy-and-hold strategy and retaliating by taking control of their own financial destiny.

I do believe that all of these reasons (and I look forward to readers sharing more of their own reasons and thoughts on this) have permanently altered the way we think about investing -- at least for many of today’s investing generation. I also believe investors are finally seeking ways to learn more about money matters. The growing popularity of Minyanville -- which seeks to empower the individual investor -- is proof of people’s desire to take matters into their own hands.

The Roman poet Horace said: “Adversity has the effect of eliciting talents which, in prosperous circumstances, would have lain dormant.”

The shattered trust will actually prove to be a precursor to growth. Once investors stop relying on the media and the pundits, once they start asking more questions from their financial advisors, it will effectively transfer responsibility of their assets from others to where it should always have been in the first place -- themselves.

Smita Sadana offers in-depth research on historical bear markets and provides you with 10 indicators she's found that together confirm the beginning of a new bull market.  Learn them today so you know when it's safe to invest again.  Bull Market Timer - 7 day money back guarantee.
No positions in stocks mentioned.

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