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SELECT ADVISORS NEWSLETTER, May 2003
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Read this issue on our website, with graphics and nice formatting:
<a href="http://www.select-advisors.com/newsletter/issues/0503page1.asp";>SA
Newsletter, May 2003</a>
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THE PARADOX OF BUY AND HOLD INVESTING
Does Time Cut the Risk of Owning Stocks? "No," Says a Nobel-Winning
Economist.
By Roger J. Schreiner, founder of Select Advisors
The paradox of investing is evident in the ownership of stocks. Since stocks
have demonstrated a long-term upward bias, most investors have been swayed
into accepting the long term buy-and-hold philosophy.
While there is some truth in the argument that a longer holding period
increases your odds of making a profit, there is a more compelling argument
that the risk of ruin increases the longer you play the buy-and-hold game.
Let's look a little closer at this paradox.
Investing in the S&P 500 index for one day carries about a 50% chance of
winning or losing. Increasing your holding period from one day to one year
increases your odds of making money for that period to about 68%. If you
increase your holding period to a decade, the odds of making money increases
to 85%. (Most investors believe the odds of winning are much higher than
those stated above, that's just because they've been bombarded with
propaganda from the mutual funds and the big brokerage firms about the
rewards of buy-and-hold long-term investing.)
Now let's expand that holding period one more giant step. One can supposedly
increase the odds of winning to 100% by holding stocks for a period of 30
years (according to Ibbotson Associates and their studies of the US stock
market over the last 100 years). When you start talking about 30 years,
you're talking about "an investment life-time." And now you're talking about
another risk - that of not having the self-control or time to complete your
mission.
Paul A. Samuelson of MIT, a Nobel Prize winner in economics, states that
"the longer you own stock, the greater the risk that you will suffer
devastating losses in a crash or a series of crashes." The risk of
significant loss increases with time. Risk does not decrease with time as
many in the mutual fund industry claim.
This makes sense when you think of it like this: If you purchase a life
insurance policy to cover you for 30 years, you would expect to pay more for
it than one that covered you for just one year. Insurance rates rise to
cover the greater uncertainty of the longer time frame. Samuelson summed it
up as follows: "To believe that there is something in the statistical law of
averages that makes risk cancel out over many years is just wrong!"
Please don't misunderstand; there are some really good things that happen to
investors in the stock market. We all had the benefit of realizing some
double-digit returns for a number of years in the 80's and 90's. However,
our positive experiences don't insure a safe future. And in some ways too
much success can actually contribute to a decline. A lengthy bull market
doesn't change the fact that the longer someone remains fully exposed to the
stock market, the greater his or her chance of a serious loss.
The fact that the stock market achieved mostly positive returns for nearly
eighteen years completely captured the imagination of the masses. Positive
returns in most years since the early 80's has helped persuade many
unsophisticated investors to become a part of the buy-and-hold investment
community. These investors were told that the worst mistake they could make
would be to miss a few days or weeks of upside action.
If one agrees with the studies presented by mutual fund companies, you might
assume that making a 30-year commitment would virtually guarantee a profit.
But there's more to the paradox than that. Real-life experience shows that
despite our best intentions, few of us have the disposition to make it
through all those stock market surprises.
Does the average investor really have the determination to hold through the
really tough periods? Can we really ride out a 50% loss like the one in
1973-74, or accept a quick drop of 33% like to one in 1987? Would we be
willing to wait out the 25 years it took to recover from the 89% wipeout of
1929? How long will it take for buy-and-hold investors to break even after
the 70% Nasdaq crash?
If history is any guide - and in truth, it is the only real guide we have -
most investors will get burned again in their buy-and-hold strategies. Not
only because it doesn't work in the long haul, but also because it makes
unrealistic assumptions about our tolerance for pain and loss.
So what's a growth-oriented, risk-adverse investor to do? We recommend
active strategies that allocate assets to the safety of cash as readily as
equity funds. While timing the stock market is difficult, numerous studies
have demonstrated superior risk-adjusted returns for professionally managed
active investment disciplines. Buy-and-hold investing may have worked for a
while, but embracing that high-risk philosophy assures you that you will
eventually encounter unacceptable losses.
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Copyright © 2003 Schreiner Capital Management, Inc. All Rights Reserved.
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