Buy-and-Hold Is More Than An Investment Strategy – It Is a Way of Thought

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People think of Buy-and-Hold as an investment strategy. It is that. It is the strategy that advises investors that stocks are always the best investment class, that market timing is a bad idea, that the thing to do is to stick to one’s stock allocation with confidence that any price drops will eventually be reversed because stocks always offer good returns in the long run.

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Buy-And-Hold Is More Than Just An Investment Strategy

But this is more than just an investment strategy. Buy-and-Hold offers a particular philosophical perspective, a way of thinking about stock investing. There are dangers to the strategy that one needs to understand the way of thinking behind the strategy to appreciate but that are often not apparent to those immersed in it.

The core philosophical premise is that investing is a rational endeavor. All of the strategic recommendations follow from that.

The subtitle to Rob Shiller’s book Irrational Exuberance describes his model for understanding how stock investing works as a “revolutionary” change from what came before. The revolutionary aspect of the Shiller model is that it rejects the core Buy-and-Hold premise of investor rationality. Reject the idea that investors are rational and all sorts of seemingly sensible strategic recommendations come into question.

If investors were skeptical of stocks, more skeptical than the Buy-and-Hold Model encourages them to be, they would always be investigating whether they were paying too much for the stocks that they buy. That’s what the people buying goods and services do in every other market that exists, Not stock investors. Most stock investors are assured by their belief in the Buy-and-Hold Model that buying stocks can never be a poor decision. It wouldn’t make sense for stocks to be priced so high that they were not worth buying! Stocks are a risky asset class. How could it ever be that investors would not demand a return better than the return being offered by the super-safe asset classes like Treasury Inflation-Protected Securities (TIPS), IBonds and certificates of deposit?

Irrational Exuberance Is A Reality

It’s true that it would not make sense for TIPS or IBonds or certificates of deposit to offer better long-term returns than stocks. But if investors are not rational, as Shiller argues in his book Irrational Exuberance, situations that make no sense become entirely possible. In a world in which irrational exuberance is a reality, it is possible for a high-risk asset class to offer lower long-term returns than low-risk asset classes. That’s the irrational part of the story.

In a world in which irrational exuberance exists, investors should be fighting it. We should all want the stock market to be as rational as possible. We have our retirement money invested in it!

But when is the last time that you read an article on stock investing that urged you to take steps to do battle with irrational exuberance? Such articles are rare indeed. The reason is that there is only one way to overcome irrational exuberance -- with market timing. Market timing is price discipline. Price discipline is the means by which all markets perform their core function of keeping prices right. Unfortunately, at times when the Buy-and-Hold strategy becomes popular, that critically important tool is lost to stock investors. Once Buy-and-Hold becomes popular, irrational exuberance always eventually grows so large as to collapse the market.

There’s a paradox at the root of the Buy-and-Hold Model. Buy-and-Holders say that stock investors should not change their stock allocations in response to price changes. If investors DID change their stock allocations in response to price changes, few such allocation changes would be needed. Each time prices went a little too high, there would be enough selling to bring them back to where they should be. Small doses of market timing do away with the need for large doses of market timing.

Opposing Market Timing

So small amounts of market timing should make Buy-and-Holder happy. But they do not. Buy-and-Holders oppose all forms of market timing. The result is that prices get out of control and the market eventually corrects prices by the only means left to it -- by crashing them. Price crashes cause most Buy-and-Holders to lower their stock allocations dramatically, the opposite of the result that the Buy-and-Holders desire.

The core philosophical question is -- Does the stock market require market timing to get prices right? If it does, then it is a terrible mistake to discourage investors from engaging in the practice. Most of the risk of stock investing is traceable to the terrible philosophical error made by the Buy-and-Holders when they came to believe that market timing is not always required. Market timing is the means by which steam is let out of stock prices before the pressure building up in them causes an explosion of severe negative consequences.

The market wants to get prices right. It cannot do the job on its own. It needs all investors contributing to the effort by engaging in market timing on a regular basis. The paradox is that, so long as we all do our part, not much market timing is ever needed and stocks behave much in the manner that the Buy-and-Holders believe that they should. The trouble begins when a large number of investors come to take the Buy-and-Hold injunction not to engage in market timing to heart. At that point, there is no longer any brake on the growth of irrational exuberance and stocks become a dubious long-term investment choice.

The market can be rational. But that is not something that happens automatically. If we want a rational market, we need to do our part to watch prices and to respond to price shifts in a sensible manner. The market is us. We supply whatever rationality is comes to possess. When too many of us buy into the core Buy-and-Hold principle that we do not need to watch prices carefully and to respond with market timing when prices get off course, stock market rationality becomes a thing in short supply.

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