Sunday, July 17, 2011

Buy and hold works but you’ll need nerves of steel


Many world famous investors have told us that you need to buy and hold shares. Statistics show over and over again that the longer you hold your stock portfolio the less risk of loss. It seems nearly counter intuitive that if you sell on highs and buy at lows that you do not necessarily outperform a buy and hold investor.

Not only that, but 'buy and hold' also works in today's market. Yeah, I was in one of my spreadsheet moods. I thought, granted you cannot time markets, but what if I sell when the market is down 10% from its peak and buy once a market has risen 10% from its previous bottom over a month's time? Those are significant moves that would likely be precursors of bear markets or of bull markets. I used the Dow Jones index from 1973 until today as my market model.

Here is the strategy described in more detail. Starting in October 1973, I 'saved' every month $100 and added it to my cash stash until the market rose month-over-month by 10% then I went into the 'buy' mode, i.e. the likely start of a bull market. If the market dropped 10% over a month I switched to 'sell' (prepare for a bear market). For the remaining time I  was in 'hold' mode. You may think that markets do not move up or down by 10% over a month, but I had 54 buys and a whopping 71 sells, with the remaining 330 months labelled as hold. When a 'buy' occurred I put all my money in the market; when a sell occurred I sold all my shares and when a hold happened, I did nothing other than adding every month $100 to my cash stash. Over the study period, I contributed $45,500 at $100 per month.

Today, if invested as described above, my portfolio would have been worth $228,151.65 (don't mind the pennies). Wow, that is impressive, I thought. I bet if I invested that $100 every month straight in the market without paying attention to market movements, I would have done a lot worse! Enter the power of the spreadsheet and I was shocked. Had I be a simpleton and ignored all market movements and just invested $100 in the market every month my portfolio was worth $277,487.13. Eh??? Let me repeat that: $277,487.13 that is nearly $50,000 more! Below the story is shown in a graph.
To see a larger version of this graph, just double click on it.

But this is without dividends! I'll bet that makes the difference. Sell when down 10%, save $100 per month plus dividends and buy when the market has jumped 10%. Yeah!!! That is… a, yes now we're talking: 365 thousand bucksos! To be precise: $365,290.99 All right! Just to be sure, let's see how the stupid buy and holders are doing when they invest every month $100 plus the dividends – losers! Eh… Eh…. Oh my gawd! They made… kid you not… over half a million!!! They made $552,246.71!!!!!

I don't have exclamation marks enough for that! Look at the graph below. I guess, ignorance is bliss, after all. What the graph also shows is that the absolute portfolio value fluctuates enormously. Look at the 2008-2009 recession; the portfolio crashed from $556K all the way down to $298K. That is a $250K swing! Can you imagine what would have gone through your mind in early 2009 when headlines screamed that the Baby boomer retirement was all gone up in smoke? Two years later, it turned out that that didn't happen after all and the ignorant buy and holder is back on top of the heap. Not only that, even during the dark days of 2009, in spite of his tremendous 'loss', the ignorant buy and holder still had a larger portfolio than his/her less fortunate siblings. Of course, all stock investors outdid the guy who put his cash savings every month diligently under the mattress or in a non-interest bearing account. That one ended up with a paltry $45,500 – but that is still more than the person who didn't save at all.
To see a larger version of this graph, just double click on it.
Ah… Godfried, you always advocate 'buying at the right price'. How did that work out in your simulation? Well… eh… red face… I did a scenario where no shares were sold but with shares only being bought after the market jumped more than 10% in one month. It turned out that the returns were not as good as that of the ignorant buy and holder, but… not by much. My strategy gave a portfolio end value of just under half a million, $484,173.64 to be precise. But this is only for the market as a whole, not for individually selected stocks.

However, considering that with increased age, the chance of me becoming less agile in the grey matter increases significantly or even for the convenience of not always having to be involved with my investments, this is for sure something to think about. Buy and Hold definitely works wonders, especially when combined with dividend reinvestment.

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