Monday, May 3, 2010

"Buy and Hold" Is Immortal

Go ahead and Google "buy and hold is dead" and you will see some interesting results. I find that most of the articles and blog posts published with these keywords were written sometime between March and May of 2009, when the stock market was at its lowest point in over a decade. I'd bet that many of these writers are in their thirties or forties and began investing ten to fifteen years ago by steadily buying mutual funds or individual stocks. I would certainly be pessimistic too if I were them! Over the last two or three years of recession, the market has seen some dizzying drops in share prices that have certainly made stomachs churn.

People continuously point out that the 10 year total return on the S&P 500 has been negative. Well, that's not especially surprising considering stocks were garnering record high valuations ten years ago. The average P/E ratio of the S&P 500 from 1998-2000 was around 40, which is about double the average P/E over the last half century.

Similarly, the 10 year total returns for the mid to late 1970's were very low. If we look to the beginning of those ten year periods, the mid to late 1960's, the S&P 500 was also trading at an above-average P/E of about 23.

Nonetheless, even if you bought into the stock market at high valuations in the 1960's, the 20 year annualized returns were still above 6%, which were even high enough to consistently outpace the rampant inflation of the time. Even stocks bought right before Black Tuesday in 1929 would have yielded a positive real return by the end of World War II.

I'm trying to make a couple of points here. The first is that even over somewhat long periods (10 years or so), stock prices can widely deviate from their intrinsic values. This means that a peak as high as that of the Internet bubble to a trough as low as that of the Great Recession may produce a negative return. In order for traditional buy and hold to work in the passive, broad index investing sense, you must have a lifelong investing time frame. The United States and world economies will continue to grow because growth is inherent to human nature and we as a species are, for the most part, intelligent, rational, and resilient.

I personally like to tweak the term "buy and hold" to something more like "buy cheap and hold." Here's an eye-opening example. Imagine you had $200,000 in cash to invest in 1990 and had the following possibilities:

Scenario 1: Put $10,000 in the S&P 500 each year for 20 years

Scenario 2: Put $20,000 in the S&P 500 each year its trailing P/E is below 25

Scenario 3: Put $40,000 in the S&P 500 each year its trailing P/E is below 20

At the end of 2009, here is how much you would have:

Scenario 1: $409,040

Scenario 2: $589,854

Scenario 3: $637,426

These results speak for themselves. In every 20 year period over the last half century, Scenarios 2 and 3 have vastly outpaced Scenario 1. So not only is "buy and hold" over the long term is very much alive, but "buy cheap and hold" is alive and thriving.

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