What’s Wrong with Buy and Hold and Averaging Down?

Buy and hold is the most popular investment strategy because it requires little or no thinking about the investment process. Of course, only the thought of this should convince you that nothing comes easy in life and therefore, in itself buy and hold must have some pitfalls. The major pitfall of this strategy is that people believe that if they buy and hold a stock, over the long term they will make money.

This is true when you are very young and you have many decades ahead of you. The problem is when you are very young - 10 years old - you don't have much money to invest anyway. The issue becomes important when you reach an age when you have a sizeable nest egg and you realize that in a few years you are going to retire.

Let's say you are 45 or 50 years old. You have your retirement portfolio and want to grow this money so that when you retire at 65 you have nice capital to live on. The problem is that when you are 50, you cannot think long-term because your investment horizon is no longer like a 10-year-old person with many decades ahead. You have only 10 or 15 years. Therefore, buy and hold has little or no meaning for an investor who is 50 years old. This investor must determine what kind of investment environment he will face in the next 10 - 15 years.

The 10-year-old investor with $10 does not care, because his capital is very small and even with a crash in the economy, he will not lose much money. Hopefully, over the next 50 or 60 years the market will rise anyway. This is a reasonable assumption. Buy and hold might be meaningful for a young investor, but has little practicality for a 50-year-old, soon to be retired investor.

Buying and holding a stock involves making an investment and forgetting about the investment. Eventually you are going to make money. It is a very simple decision and there is really not much work involved. Now we have to talk about returns to better understand the risk involved in thinking long-term. In this type of investment approach, the market - over the long-term - has provided a return of roughly 10 to 11% - 8% due to capital gains and close to 3% in dividends. Advisors say that since you can expect 11% over the long-term, why try to do much else? Just find a good stock and wait for the capital to grow.

There is a major pitfall with this argument. And it is that the market does not provide a return of 10 or 11%. That is an average. This average is from periods when the markets do not do anything for many, many years, and periods when the market goes up 20-30% per year. Let's look at what happened last century.

The S&P 500 in 1928 was 17.66. In 1949 the S&P 500 was standing at 16.76 - for 21 years the market had actually gone down. Looking at the Dow Jones Industrial Average, in 1900 the Dow Jones was standing at 77.66; and in 1932, it was standing at 50.16. Here we have a span of 32 years where the market was not doing much. Another more recent period is 1968-1982. In 1968 the S&P 500 was 100.53, and in 1982 it was 109.65. Again, a period of 14 years where the market has provided no returns. In this last period, some people might suggest that stock yields were higher. However, in that period, money market mutual funds provided returns in the 10-15% range, which were much higher than the yield provided by stocks.

Buy and hold is an average. If the market has provided a 10 to 11% return, it is because there have been periods of 10, 15, even 20 years when the market did nothing, and periods of 10-20 years, like the period from 1982 to 1999, when the market provided close to 20% per year return. When you average these two periods, it comes out roughly the average long-term return. Buy and hold is dangerous.

Let’s say a 55 year-old investor is planning to retire in an environment like we had in 1968, and he wants to invest over the so-called long-term. By 1982 he has experienced several serious bear markets with its capital declining by 20-30% each time. If he or she is lucky, by 1982 he or she breaks even. This is a nerve-wracking experience indeed.

Investing blindly is not a solution. The risk is always there, whether we want to believe it or not, and the knowledgeable investor has to recognize the conditions that might create a period of well-below average returns. Another pitfall or risk of buy and hold is that if the market, as in the 70's, goes down 30-40%, investors believing in long-term investing would be seriously shaken because their assets were reduced by 30-40%. Managing volatility of return is still an issue the investor has to face.

Another way of investing is averaging-down. By following this strategy, investors decide to increase their investment in stocks by a given amount of money with some regularity. For instance, an investor decides to invest $50 or $100 every month in stocks. With averaging down people are urged to keep investing even if the market declines. By investing the same amount of money as the price of the stock declines, the investor owns an increasing amount of shares of that particular stock. This is a mechanical rule that has a lot of appeal because it requires not much work and not much understanding of what goes on in the market place.

This investment strategy is based on the assumption that the market always goes up; and as we saw before, the market does not always go up, there are periods where the market can provide no returns for maybe 10-20 years. The averaging down strategy consists in buying more shares or investing more as the price of an asset declines. Again, this is one of the popular, easy formulas because they are simple to understand and there is not much work involved.

The problem with this strategy is that as every poker player knows, when you have losing cards in your hand, you're better off saving your money and fold. What is the rationale of continuing to invest when the market declines 30-40%? Why keep losing money? Losing money seriously impacts the total return of your portfolio.

It is considerably more profitable to wait until the conditions are better with a little bit of work and then start investing when the time seems to be more appropriate. No serious investor buys in a declining market because the probability of losing money is very high. Serious investors buy when the market is oversold and starts rising, when there are serious reasons to believe there is a turning point underway and the market is turning up. There is no easy way of making money or managing volatility. Making money, as any businessperson or investor knows, is very difficult and intensive work. It is a knowledge-based "game", and the following pages will provide you with further information on how to play it successfully.

There are no easy formulas in investing. Everybody would be a millionaire. Successful investing is a process that takes time and dedication. The objective of this book is to provide a framework to begin managing your money, recognizing why asset prices change, so that you can make informed decisions according to the odds you have of making money.

(From my book Profiting in Bull or Bear Markets)

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

Disclaimer.The content on this site is provided as general information only and should not be taken as investment advice nor is it a recommendation to buy or sell any financial instrument. Actions you undertake as a consequence of any analysis, opinion or advertisement on this site are your sole responsibility.

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