Investing

Some say the crash of 2008 put an end to the cherished belief that buying shares for the long term is your best bet. Let’s discuss the pros and cons of this approach.

FOR BUY AND HOLD

You’re the CEO

Thinking like an owner is the best way to approach investing, and it’s synonymous with long-term strategies. A company’s ability to increase its earnings over five years and beyond is a prime driver for its share price and therefore shareholder returns. If you believe something has happened that undermines the business model of the company in which you have invested, then it’s time to sell. Otherwise, keeping a stake in a quality business that grows over the years is your best bet.

Bar of soap

“A portfolio is like a bar of soap, the more you handle it the smaller it gets.” There is evidence that the most active sharemarket participants perform the worst. A study by US academics of 66,500 individual investors found that traders generated returns that were 36 per cent lower than the market. The biggest culprit in this result, the academics postulated, might be overconfidence, which drives investors to trade more than they should.

No tail chasing

Committing yourself to the long term helps guard against making the wrong decisions based on fear or greed. Chasing returns is like chasing your tail. A famous study by Morningstar showed that between 1988 and 1994 the average annual performance of 199 mutual funds was 12 per cent, but the investors in these funds managed only 2 per cent. The persuasive explanation was that retail investors were getting in and out of funds at the wrong times, essentially buying high and selling low.

Irrational behaviour

Psychology drives asset prices over the very short term. A rational investor should not base future prosperity on the irrationality of others. Business cycles go up and down over longer periods, but a low point may be the opportunity to snap up more shares in the companies you like at a discount. Growth assets like shares are volatile, you need fortitude and a plan – a commitment to buy and hold can provide that. Just remember, over 10 years and beyond shares generally outperform all other asset classes.

Knock-on effects

Excessive focus on the short term has a nasty effect on professional fund managers who can’t afford to have two years of bad numbers. This has knock-on effects in the corporate world, where executives feel they need to deliver positive short-term news to keep their investors happy. The loop closes, says Hyperion’s Manny Pohl, when company management teams let the long-term strategy of their businesses flounder by making short-sighted decisions, and investors suffer.

AGAINST BUY AND HOLD

Japan in the dock

Exhibit A: During the global financial crisis, the local sharemarket fell 55 per cent in 16 months. And we’re still 36 per cent below the peak we reached in November 2007. Exhibit B: Japan’s sharemarket has never fully recovered from its crash in the early 1990s. There’s volatility, which can be handled; and then there are the types of violent, global disruptions that can wipe out half the value of your shareholdings in a matter of months. Sticking your head in the sand won’t protect you against those kinds of events – and there look to be more on the horizon.

Bitten the dust

Buy and hold has looked great in the multi-year bull run, but the GFC put an end to that. In fact, the world may be going through a much longer bear cycle. The big developed countries – in Europe and North America – are going to have to grind their way through a slow recovery as households and governments pay down debt to a sustainable level. Until that happens, the risk of another crisis remains high, as do tensions. That paints a picture of slow growth in a volatile world – not the kind of market in which to be passive.

Feeble excuse

The mantra of “buy and hold” can mask an unwillingness to make decisions in the face of uncertainty. It can be an excuse for inertia, a psychological bias as damaging as fear and greed. It can make you more prepared to believe that a business sputtering along with sub-par performance will eventually “come good”, and when it doesn’t, all you have are years of poor returns to show for it.

Not worth it

You’re in for a hiding if you buy even great companies at a very high price and then hold. There’s evidence that buying at a high price-to-earnings ratio makes it difficult for the company to generate the return you want over the longer term – which makes sense. That means buy and hold is no panacea for long-term returns. In fact, you are betting that you get everything right in the first place, and you discover whether it was the right move only years down the track.

Not in the Stone Age any more

The buy-and-hold strategy got its grip on individual investors at a time when there wasn’t the plethora of tools and data now available to anyone trading shares through an online broker. For example, you can look at the trend of the share price and the moving average, perhaps over the past 10 months, to get an idea of where the stock is moving. The amount of up-to-date information at the fingertips of any individual with internet access allows for a more dynamic approach to investing.

Si view: over the long term, buy and hold is still the best strategy. That’s not to say you should never sell; it’s not an excuse to sit back and do nothing. Invest with the aim of holding, and stay alert for risks, as well as other opportunities. It’s buy and hold, and monitor