Buy and Hold, R.I.P.: 1900-2007: For Those Who Maintain at Least Two Classes of Holdings, One to Trade and One to Invest, Buy-and-Hold's Demise Presents a Problem. for Many, Active Investment in Exchange-Traded Funds and Even Futures Are Replacing These Passively Held Stock and Mutual Fund Holdings. Here's One Strategy to Help Fill the Void

By Ruggiero, Murray A., Jr. | Modern Trader, February 2009 | Go to article overview

Buy and Hold, R.I.P.: 1900-2007: For Those Who Maintain at Least Two Classes of Holdings, One to Trade and One to Invest, Buy-and-Hold's Demise Presents a Problem. for Many, Active Investment in Exchange-Traded Funds and Even Futures Are Replacing These Passively Held Stock and Mutual Fund Holdings. Here's One Strategy to Help Fill the Void


Ruggiero, Murray A., Jr., Modern Trader


Classic financial planning says that investments in both the stock market and real estate are the keys to building long-term wealth. The implication is that both these assets outperform inflation and should be invested in steadily over time. The popularization of this concept among the American middle class, and the common method for applying it that involved investing a certain amount ($50, $100, $1,000, etc.) month in and month out, fueled the rapid growth of no-load mutual funds. The "trading" restrictions on these investment vehicles only further bolstered buy-and-hold's popularity.

Now, however, with stocks and real estate in turmoil and most investors convinced that buy-and-hold is a fool's game, investment companies are loosening their restrictions. Many fund families, such as Rydex, have no redemption fee. This means they can be used for market timing because they don't have any penalties for active trading. Exchange-traded funds (ETFs) have made "active investing" even more accessible. If you're so inclined, there are now ETFs that are both positively and negatively correlated with the S&P 500, Treasury bonds and even sectors such as currencies, precious metals and energies.

In 2008, seven years of stock market gains were lost. Century-old financial monoliths went bankrupt. Terms such as "dollar cost average" have become anathema. Following this historic shift, a review of the previously unassailable buy-and-hold approach is in order, along with some suggestions of what should come in its wake.

A HUMBLE BEGINNING ...

The popularity of buy-and-hold increased in earnest in the mid-1960s, perhaps culminating with the landmark paper "Efficient Capital Markets: A Review of Theory and Empirical Work" by Eugene Fama Sr. in 1970 and the book "A Random Walk Down Wall Street" by Burton Malkiel in 1973. However, the roots of the concept were hardly new.

French mathematician Louis Bachelier, who later gained notoriety for his work in Brownian motion, published papers in the early 1900s and concluded that "past returns have no predictive value on future returns. Both were statistically independent." The concept of Wall Street stepping to the beat of a "random walk" was born.

Half a century later, British statistician Maurice Kendall (1953), the University of Chicago's Harry Roberts (1959), along with Fama, showed evidence of "statistical independence" in stock returns and the "nil predictive power" of various techniques of "chartists."

Paul Samuelson and Benoit Mandelbrot demonstrated a decade later that such randomness could coexist with a link between fundamentals and stock price, explaining that such randomness in returns is expected from a well-functioning stock market: "Investment in stocks is a fair game." The "fair game" concept is that today's stock price (with all available information) reflects the expectations of investors. Therefore, tomorrow's price should change only if investors' expectations change, which should be randomly positive/negative as long as investors are unbiased. This is the core of the Efficient Market Theory (EMT).

EMT was not universally accepted, however.

In 1980, Sanford Grossman and Joseph Stiglitz argued that an extremely high level of market efficiency is internally incompatible as it disallows the profitable opportunities that motivate security analysis to produce information. In addition, market "frictions," they said, limited market efficiency and the level of efficiency differed across markets, depending on costs of analysis and trading.

Further, by the late 1970s and early 1980s, inconsistencies such as seasonal tendencies became apparent. For example, one involved the likelihood that small-capitalization stocks accelerated in value in January. Arguments against these tendencies included one that this "January effect" was a premium necessary to compensate investors in small stocks, which tended to be illiquid at the turn of the year. …

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Buy and Hold, R.I.P.: 1900-2007: For Those Who Maintain at Least Two Classes of Holdings, One to Trade and One to Invest, Buy-and-Hold's Demise Presents a Problem. for Many, Active Investment in Exchange-Traded Funds and Even Futures Are Replacing These Passively Held Stock and Mutual Fund Holdings. Here's One Strategy to Help Fill the Void
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