Should Buy and Hold Investing Be Scrapped?

“In the long run we are all dead” goes the famous quote from John Maynard Keynes.

What Keynes was suggesting is that economic (and thus financial) theories are meant to hold true over the long run, potentially longer than any one’s lifetime.  Over the short run there could be substantial variances from where those theories suggest normalcy should reside.  Individuals could be waiting a very long time for reality to actually intersect with long run theories.  In other words, timing actually is everything.

Investors have witnessed firsthand a similar script over the last 20 years as there have certainly been very good times to buy equities but also very bad times.

Buy and hold investors spent much of the last 20 years wondering if they made the wrong decision.  Buy and hold, the theory states should work over the long run. However, for buy and hold not to work for 20 years, or over 1/3 of one’s adult life, would be detrimental from an investing standpoint for countless numbers of reason.

Depending on which year you happened to actually invest capital made a world of difference as to the reality of your success today.

If we haven’t learned anything the last two decades, then at least let us realize that when it comes to investing over the long run, timing actually is everything.

Monopoly Money 

Consider this scenario:

You just inherited $100,000 and are wondering what asset to buy.  You have just watched the markets skyrocket in two bubbles the last 20 years, crash in two hangovers afterward, and now again enter levels that are lofty historically.  Depending on when you chose to invest that money was the one single most important factor in its performance over the last 20 years.

Not the stock you chose, not the dividend it paid, not even the asset class itself mattered more than the timing of that decision. (For more on why stock picks don’t matter near as much anymore see this video about diversifying in today’s environment)

Figure 1 below displays the annual performance of the S&P 500 from the dates shown through today.  Depending on which year you happened to put money to work was the most significant factor in your annual returns.

Figure 1: Average Annual Return From Given Year through Today

Modern financial theories such as Buy and Hold also suggest that the earlier you invest the better and more robust your returns will be.  They suggest that over the long run you will be better off.  They are wrong as Figure 1 shows over the last 15 years, the earlier you invested in equities, the worse off you were.

It shows that most importantly is timing, as someone back in 1999 should have in hindsight sat out of the stock market (NYSEARCA:SDS) completely until 2009, being invested in basically any other asset while they waited.  In 2009 the timing for equities was the best it had been in over 15 years as the average annual return of stocks through today was below 10% every year the past 15 until 2009 when the average annual return was above 15%.  The timing in the late 90s and early 2000s was one of the worse, but in 2009 was one of the best.

Keynes could not have been more dead on.

In the long run we are all dead, therefore we shouldn’t use theories for time horizons that don’t align with our own.  We need strategies that work better over shorter time frames.

A Better Way to Time

In our December ETF Profit Strategy Newsletter published 11/22/13 we provided analysis displaying how overvalued stocks (NYSEARCA:IWM) were compared to another popular asset, Treasuries (NYSEARCA:TLT).

“As has been the case time and time again in history, this time is not different, mean reversion will occur, and the bond versus stock equilibrium will eventually return to more normalized levels likely resulting in much lower equity prices.”

Although this is expected to play out over the next few years, already Treasuries have outperformed stocks by 4% in only two months.

The chart below is similar to the one provided subscribers in that Newsletter and shows the valuation relationship between stocks and the Case Shiller Home Price Index (NYSEARCA:XHB).  Which one of these assets should you put your $100,000 into today?

Figure 2: Stocks versus Real Estate – 15 Year Valuation

Based on the past 15 years of valuations, right now stocks are getting expensive compared to the average home price since the median price for the S&P 500 is around 8.5x the Case Shiller home price index.  Based in home value, the S&P is again approaching year 2000 price levels.

Using relative strength analysis like Figure 2 displays can help investors visually see price comparisons across assets.  Someone with money to invest in either stocks or real estate in 2000 looking at this tradeoff would have quickly seen that stocks were significantly overvalued compared to real estate.  Likewise, in 2005 and again in 2009 stocks were significantly undervalued compared to real estate.  Investing in stocks in the mid-2000’s or in 2009 would have been a much better choice than real estate.

Today, similar opportunities exist when deciding whether to invest in stocks, bonds (NYSEARCA:JNK), real estate, and gold (NYSEARCA:NUGT).

The ETF Profit Strategy Newsletter uses relative strength and other technical, fundamental, and sentiment analysis to help investors find themes for the long run.  Our Mega Investment Theme report focuses on the 10 key topics for investing in 2014 including equities that are now at lofty valuation levels.  This is true not just when measured by the typical U.S. dollars, but also when measured by the purchasing power of other assets such as real estate and bonds.