Tip #3: Exploding the Myth of Buy and Hold Investing

"Those who live in glass houses shouldn't throw stones." American Proverb

"Gentle Reader." Now this is a term/literary device whose usage was last prevalent during the Victorian era. But in the century or so since, it has been increasingly out of favor in the world of literature. People generally find it to be bracing and intrusive to a narrative, taking them out of the moment, if you will. But I have always been rather fond of authors who make use of of it. To me, there is both an intimacy and a fondness connoted when I read it.

Why wax nostalgically upon an archaic literary device that most contemporary readers dislike while penning a blog about investing? Well, Gentle (and hopefully patient) Reader, I found a most embarrassing error several days after posting my last blog. While fulminating at the incompetency rife throughout the financial services industry, I noted that those employed therein were largely, among other unflattering nouns, "imbiciles." While being the only word that was misspelled in my last missive (and corrected since then), the irony of this particular faux pas is not lost upon me.

Now who knows? Perhaps no one made it to the eighth paragraph to even spot my blunder. I would like to think, however, there were those that saw it and refrained from sending me a rather pointed comment noting the extent of my intellectual failings. That was kind.

But on to the third tip of seven regarding the investing lessons I have learned. From my perspective this is the most important of the series and will be perhaps the most controversial.

There is a certain type of smug investor who I am sure is fully on-board with my first two investing tips (in short, they are 1) avoid following the crowd and 2) eschew expensive financial products/professionals). This investor has read the books proving most people lose money by using a "rear-view mirror" approach to investing (what was the hot performing stock/mutual fund/sector/country last year?) as well as the fact that Wall Street as a whole does not beat the market.

Accordingly, this investor resolutely advocates that the only sensible investing strategy is to simply buy a suitably comprehensive low-cost index fund (say the S&P 500, or, better yet, the Wilshire 5000), and hold it until one needs the money in retirement. Sometimes called "Bogleheads" (after John Bogle, the revered founder of the Vanguard Group and stalwart proponent of index-fund investing), these individuals are among the most stoic and disciplined investors on the face of the planet. Whether markets are deemed to be high, low or in between, they just keep contributing to their 401(k), IRA and/or brokerage accounts every payday.

Undergirding the supreme confidence these investors have in the superiority of their approach is the devotion to the concept of "efficient markets." In brief (sorry for the foray into macroeconomics for those of you who eschewed the stuff in college), the efficient markets theory posits that whatever the price of a particular asset or index is at any given time, it is the "right" price. By that I mean that it reflects all the relevant publicly available information. Hence, any attempt by naive investors (such as myself) to proclaim that certain assets might be bargains, while others are overpriced, is unprofitable guesswork.

Why? Because any information/insight that I am using (assuming I am not acting upon illegally obtained insider information) is available to everyone else in the marketplace. So if I see an asset selling for $10 that is really worth $11 based upon its intrinsic value, one of two things will happen according to those who adhere to the efficient markets theory. The price could immediately jump to $11 if my belief that the asset is undervalued is predicated on sound information and analysis, as everyone else in the marketplace would see the same opportunity. While there might be a few quick traders who make a buck as the market price almost immediately jumps to $11, the vast majority of investors would be unable to profit. Alternatively, if my analysis is incorrect due to either false information or faulty thinking, I will make no profit and the market price will stay at $10.

For those self-satisfied Bogleheads out there, the fact that every year some hot fund managers beat the market does not in any way shake their confidence that trying to outsmart the market is a loser's game. They very calmly note that any bell distribution curve representing all active mutual fund managers would have at the far right hundreds of individuals whose seemingly extraordinary performance is explained by pure chance. They are in essence the coin-flipping monkey who tosses heads eight times in a row; a rare event, but one that has nothing to do with inherent skill. After all, two, and even three standard deviation events happen all the time in the real world.

I know the psychology of Bogleheads so well you see, because I used to count myself as one of them. Between 1998 and the early part of 2000 I was supremely confident that trying the beat the market yourself, or, worse still, paying some financial adviser to do the same, was futile. However, let me assure you that after being an investor over the course of the most tumultuous decade in finance since the 1930's, I am absolutely convinced that the "buy and hold forever" investor achieves less than optimal returns.

Before considering the evidence, I want to challenge the analytical underpinnings and assumptions that form the basis of efficient-markets theory. The most important viewpoint with which I take issue relates to the market itself. As noted above, the buy and hold investors look at the market as sort of an omniscient deity; the manner in which it prices assets is always "right," reflecting the collective wisdom of all market participants, who in turn are acting both with access to all relevant information and in their own economic best interests. This last assumption means people are "utility maximizing individuals," or, more plainly stated, that we generally act in a rational manner so as to increase our own wealth. This has been a core assumption of orthodox modern economics for many years.

After being an investor for over a decade, I have a very different view of the market. Rather than the accretion of the best and brightest market participants, whose wisdom exceeds any single actor or even set of actors, I posit that oftentimes the market is more accurately an aggregation of stupidity, naivete, impetuousness, and short-sighted thinking. Quite a stark contrast to the orthodox view, I must admit. Now I should qualify this view to some degree. Specifically, as the asset markets veer to the extremes in prices, the market itself is governed less by profit-maximizing, rational thinking. Rather animal spirits (greed in the time of raising prices, and fear in the time of declining prices) grip most market actors and induce them to act in ways that are not in their own long-term economic self-interest (but is very much in the interest of contrarian investors who take the other side of their trades).

As I mentioned, I was a staunch believer in efficient-markets theory and had been so since my sophomore year in college when I read A Random Walk Down Wall Street for my Macroeconomics class. My Road to Damascus experience came in the Spring of 2000. Specifically, the day was March 10, 2000. I was sitting at my desk trying to draft a legal brief, but my mind was on the other side of the continent. In NYC, the NASDAQ had just surpassed 5000 (almost 10 years later it is trading for less than 45% of that level)! For those of you who may not have been following investing back then, this capped an unsurpassed rise for the NASDAQ from a low of 1200 less than three years previously. No major stock index had ever increased by more than 315% in 35 months.

My intellectual worlds were colliding in a most irreconcilable manner. My college and graduate economics background was telling me that the prices levels for the NASDAQ and the high-flying stocks of which it was composed must be justified and sustainable. Why? Because that is what the market was saying.

But just like Keyes (played brilliantly by Edward G. Robinson) in the film masterpiece Double Indemnity, I had this "little man" inside of me, telling me something was amiss. Nothing made sense. The vast majority of companies seeing really stratospheric increases in their stock prices were the ones that made no actual profit, much less paid any dividend. When I queried my friends who owned many of these stocks as to the nature of their businesses, I often received smug, but vacuous, remarks about how XYZ.com was using the internet to leverage its sales. But sales of what? Many of these investors did not really understand what these companies were specifically hoping to do.

This March day was largely wasted from a billing hours perspective, but was transformative for me as an investor. Eventually I concluded that, despite everything I had taken away from my academic training, it was possible to "outsmart the market." At least at that point in time, where greed and the desire for fast riches seemed to be blinding people to the fact that speculation, as opposed to investing, usually ends in tears. Hence, I placed my first short order (an investment whereby you make money if the price of a stock goes down, but lose money should the stock price appreciate) that same day.

In the decade since that time, I have found that the market has repeatedly "mispriced" a plethora of assets: the overinflated US Dollar, cheap gold, undervalued emerging market equities, overvalued real estate, overly affordable industrial and agricultural commodities, as well as expensive (October 2007) and then cheap (March 2009) stocks. Fabulous opportunities to both buy and sell various assets have consistently presented themselves throughout this most tumultuous decade.

Before closing, let me briefly examine the perils of buy and hold investing. Its proponents point to the fact that over very long periods of time, one would not have lost money investing in a broad US stock index, assuming dividends were reinvested, during any twenty-year time period in the stock market's history. I think there are many investors who find that to be cold comfort after seeing what happened in 2000, and then again in 2008. Importantly, had an investor bought the S&P 500 index ten years ago and held it through the middle of this year, she would have zero capital appreciation to show for it. Once inflation is factored in, the investor would have lost purchasing power on her investment even if dividends are considered. During that same time period gold (a most despised, and hence incredibly attractive, asset in 1999) has increased in value four-fold.

Another example showing the pitfalls of buy and hold investing relates to a question I used to pose to people in the era of the tech crash of 2000. I would ask, "What is the longest period of time one could have invested in the broad US market and received zero capital appreciation in real (inflation-adjusted) dollars?" Back in 2000 people were still very unaccustomed to sub-par returns in the stock market. Answers I received varied from as little as 3-5 years, all the way up to about 15 years. The correct answer - 55 years (1929-1984). That is a long time to be patient. While the proponents of buy and hold investing will point out that in the "long-run" people have never lost money in the markets using their approach, I am reminded of John Maynard Keynes observation that, "in the long run we're all dead."

The moral of the story? Buy and hold investing is terribly flawed and will cost you large sums of money if you are buying and/or holding over-valued assets!! Do not misunderstand. Buy and hold investing is superior to almost all other market strategies. And if you are going to make an investment mistake, this is probably the least bad one to make. But one will be far better off eschewing assets when they are being bid up beyond price levels justified by sound fundamental valuation analysis.