The biggest lie in finance – buy and hold

There are lots of lies in finance or more subtly put, a lot of things wrong with conventional wisdom. I have trouble deciding which lie is the biggest but definitely one of the candidates is ‘Stocks for the Long Run’ which usually means that buying and holding the market index is the best way to generate wealth over the long term. Basically, this lie is made of two parts; that buy and hold is a superior investment strategy over the long term and that passive investing is also superior over the long term. The problem is that these are true only some of time and that such strategies severely understate certain risks. Lets look at the details.

The first problem with buy and hold is that there are significant periods of time when stock returns do not compensate for the extra risk of investing in them. The chart below shows stock vs long term gov’t bond returns over the last 10, 20, and 30 yrs. The data is from Rob Arnot and can be found here.

We all know that the last 10 yrs in stocks have been terrible but even over the last 20 and 30 yrs stocks have not provided a very large return over bonds. Of course, the last 30 yrs witnessed the largest bull market in bonds in history but we also witnessed one of the largest stock bull markets in history. Its just that the bond bull market hasn’t ended yet.  What if we look at longer periods of time and also overlap those periods so that we aren’t stuck in a given 10, 20, or 30yr window. Fortunately, that data is available. The chart below is somewhat confusing but very interesting. It is from this paper and uses Shiller’s S&P500 index data, the gold standard in index data. The chart shows the distribution of total return (dividends plus capital gains) of the S&P500 over different holding periods using performance data back to 1900.

Lets take a 20 year holding period as an example. The data for the 20 yr holding period is put together by looking at the return of a portfolio starting in 1900 and holding it for 20 yrs, then taking a portfolio in 1901 and holding it for 20 yrs, etc… and then looking at the total returns. The green line shows the median (middle) return, the light blue boxes show the 25th and 75th percentile of returns, the blue whisker shows the maximum return and the red whisker shows the minimum return. The variations of returns are huge and the uncertainty of the return increases with time! You can end up with much more than you thought based on long term averages or much less than you thought. The low point for the 20yr holding period is a total return of 90% or about 3.3% annualized, barely keeping pace with inflation of about 3%. The stats are better for longer holding periods but still show a huge variation in the final outcomes.

Why is the variation in outcomes so large? One of the reasons is that the stock market is prone to large negative shocks on a much more frequent basis than expected by modern finance theory. Large negative returns devastate portfolios. The passive buy and hold mentality far underestimates the effect of such large negative returns. The chart below shows the number of large negative events for the S&P500 vs what is predicted by finance theory.

The large drawdowns are what lead to long periods of sub par and even negative returns. And here is the worst part. If you follow a buy and hold passive strategy your fate as to where you fall in the return distribution is largely determined by when you were born. Some call this type of risk birthday risk. Obviously, if your wealth building period was from 1981 to 2000 your total wealth would have been far different from someone with a wealth building period from 1961 to 1980. Neils Jenses at Absolute Return Partners has a great discussion on birthday risk which I encourage you to read.

In summary buy and hold investing is far more uncertain and risky than the conventional wisdom would have you believe. What you buy matters. When you buy into an asset class matters. Price matters. You cannot just rely on time to make up for the larger than expected negative events that take place in financial markets. Maybe you can if your time horizon is 50 yrs or so but most investors don’t have such investing horizons. Despite what the conventional wisdom says an investor can build superior long term wealth with less uncertainty through an active strategy with good risk management. The strategy I advocate on this blog is focused on dividend investing but it is definitely not the only one.