Since the 1970s, money managers have encouraged investors, particularly retirees, to buy and hold strategies. The buy-and-hold strategy became synonymous with a conservative and reasonable approach to saving, particularly for retirement, where the investor would pick stocks of value and give the investment time to grow.
The basic idea, one that was encapsulated in the Efficient Market Hypothesis, is that it is difficult to outperform the market on a risk-adjusted basis. Earning the market rate of return, without attempting to time the market, would provide sufficient means for a comfortable retirement. The retiree or investor could invest his savings, knowing that time was working to increase his income in a positive direction.
This approach earned a cachet with baby boomers as they put their savings away for retirement. From 1970 to1999, the average mean return for large company stocks was 14.9 percent, with a standard deviation of 15.98 percent. Therefore, on average, approximately 68 percent of the time an investor would earn between 1.08 percent and 30.9 percent on their investment.
An investor would not earn more than the yearly range, but the market was generating high income and positive returns, and the potential for an investment loss was lower, such that buy-and-hold provided what seemed like a relatively smart method for both reaching retirement and long term investment.
The exchange-traded fund ETF was introduced in 1993 as a vehicle for index investing with the added benefit of tradability throughout the day. Unlike popular mutual funds, ETFs operate like closed-end funds, in that shares trade in the secondary market between buyers and sellers, and fund managers do not create or destroy fund shares as the popularity of the fund decreases.
Ultimately, the big question facing investors today is whether ETF returns are better than mutual fund returns. For instance, ETFs tend to have lower expense ratios than mutual funds. But it also has relatively higher trading costs comparing to funds. Balancing earnings and expenses against each other is a worthy consideration. Beyond this option, ETFs can provide an easy route to buy and hold strategies and are easily accessible on any stock trading platform.
Return on Buy and hold
Unfortunately, the returns and volatility in the market over the last 15 years, however, have called into question such complete faith in the buy-and-hold strategy. Between 2000 and 2013, the average mean return was significantly lower than what the typical investor was used to seeing, at 5.56 percent, and perhaps more significantly, the standard deviation was higher, at 19.89 percent.
This would suggest that approximately 68 percent of the realized returns are likely to decrease to between 25.45 percent and 14.33 percent. Today, investors struggle to get the positive returns they were accustomed to, and the probability of negative returns in any given year is greater than an increase in profits.
When monitoring the historical data, the result was surprising to discover so much variability in compound returns for the NASDAQ ETFs. Given the historical results after the financial crisis of 2008, it is relatively unlikely for an investor to gain a positive compound return on the ETF investment, such as NASDAQ ETFs, with a buy and hold strategy.
Given the volatility of the stock market, it becomes less likely that the average investor would be willing to hold for the length of time necessary, riding through the downs of the market. For intelligence investors, this suggests that perhaps buy-and-hold is not a strategy that is as effective as it was once thought to be.
Would you be willing to continue to hold an investment if you saw the market value below your principal after five years? For investors who lack basic investment knowledge, and even for finance professionals providing the advice, the importance of this result is that a no to this question impacts buy-and-hold planning.
Our readers must notice here that our view is not an indication that if you hold on long enough you will not be able to generate a gain, it is just that it is less likely that many investors will do so in this more volatile stock market. For intelligent investors, the buy-and-hold strategy is not recommended.
How many clients of advisors or individuals can stay the course if they see a decline, or no gain, in ETFs principal? Behaviorally for investors, this could be magnified because many individuals saving for retirement may have expectations that rely on old rules of thumb for returns and have not started saving for retirement until later in life. This finding is relevant because it may tell us we need to dramatically change the way we view the common wisdom of passive investing.
Further exacerbating the lower likelihood of success with buy and hold is the small percentage of ETFs that survive through the holding period requirements. Investors must be wise about the ETFs they choose. It does look like ETFs categorized by market capitalization do pronouncedly better than ETFs overall.
Recommendation
When you look back at the original buy-and-hold recommendations, investment under buy-and-hold was directed towards a broadly diversified market index fund. A positive return does appear to be more likely among this diversified categorization, which might ultimately support the idea of buy-and-hold.
While certainly not conclusive, more research in this area is warranted, as it appears long run average returns may not be a good indicator of future performance and are at best in the current environment, a relatively high upper bound on portfolio performance. Our focus is on the buy-and-hold strategy that we have applied to ownership of ETFs, but advocates the approach originally intended for investors to include mutual funds into their portfolio.
Because the two products are not exactly the same, investors must use algorithms to investigate the returns of mutual funds before and after the marked increase in market volatility, to decide.
Beyond the application of our study methods to other investment products, consideration of buy and hold versus other strategies or simple trading rules would highlight whether buy and hold is a strategy for an old era in stock market investing.
Ultimately, these instances are more about bigger considerations involving how academics measure risk versus how investors experience it. If risk is best captured by price volatility, then a world with a lot more volatility may mean that the old advice and the old strategies to wait and see do not serve investors as well. If the market has fundamentally changed, so must the advice for getting that profit to retirement.
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