Wednesday, December 05, 2007

The Buy and Hold Fallacy

I notice one very distinctive trait of many investors, which is the flawed view of the "buy and hold" strategy. Many investors believe that as long as the fundamentals of a company are sound and that the company is making profits, they can simply hold on o their shares forever until they are "above water" again (meaning they can break even or make a small profit). A lot of traders and speculators also unwittingly become "long-term investors" when a stock they buy tanks below their cut-loss point, making it much too painful to realize the loss. They then hold on to dear life wishing for the stock price to rise to their buy price in the future. Others simply buy and hold because they believe that one should go long-term for shares, irregardless of how the company's underlying business is doing. Thus, they may end up with a dud company trading at 3 to 4x PER languishing in a commodity business and giving a paltry dividend yield of less than 2%.

Let us not get this wrong: there is nothing fundamentally flawed with the principle of buy and hold, and this strategy has proven to be effective through market volatility and different economic conditions. However, what I wish to clarify is that one should not buy and hold BLINDLY. There are several key points to note which make "buy and hold" different from value investing per se, and these involve a close look at the price you pay for an investment, as well as the quality of the underlying business. Let's examine these factors more closely:-

1) Price Paid - An investor must always examine the fundamentals of the company and its earnings, including future earnings and dividend prospects; in order to decide how much to pay for an investment. If the price paid is too high (refer to my posting on Investment Mistakes under "Asiapharm"), then it will take a long time for the value of the business to catch up with its price (if ever !). Eventually, the buy and hold may turn in a very small gain if the original price paid was too high (like in the dot.com bull run which saw valuations reaching stratospheric levels).

2) Deteriorating Fundamentals - No amount of buy and hold can save the investor from a permanent loss of capital if the company's fundamentals deteriorate. It may be anything from higher cost of goods sold, entrance of a powerful competitor, loss of monopolistic pricing or lower barriers to entry for the industry (e.g. liberalization of certain rules or laws); but the effect may be debilitating and permanent. An investor has to constantly keep up with news on the industry which affects his investment, in order to be able to react accordingly and sell if he sees long-term trouble ahead. Admittedly, this takes some skill and foresight; but an investor cannot afford to be passive, otherwise if he checks back 10 years later he may end up with only a fraction of his original investment left !

3) Opportunity Costs - Another demon associated with buy and hold which is often overlooked by investors is that of opportunity costs. This means your money is "locked up" in a useless investment generating sub-par returns which cannot even exceed the inflation rate (currently at 3.6% p.a.); while other opportunities whizz by you. Opportunity costs are the single most insidious aspect of a flawed buy and hold strategy, as it deprives the investor of much needed funds to channel to a more promising investment with good growth potential. During the subsequent bear market after the dot.com bubble burst, many investors were saddled with useless investments in which they could not bear to divest, thus depriving them of much needed cash to buy when prices were depressed.

Thus, the above illustrates the dangers of "buy and hold" when applied wrongly, and this is frequently seen on stock forums where people claim that as long as they "buy and hold", they will eventually make money or recover their losses. Remember that a stock does not know that you own it, thus there is no emotional or logical reason for a share price to move back to your BUY price, as it is totally unaware of you as a person. The bottom line is not to get too emotional about your investments, and to view them objectively as investments which should give you an adequate rate of return.

14 comments:

MM said...

MW,

Good piece. Though we are on different strategy, I hope more aspiring value investors would read your blog and truly understand the meaning of value is not equal buy and hold.

WB also lamented that he should have sold Coca cola back in the 90s when it peaked.

A stock chart actually will break down about 3-6 months before the fundamentals deterioration start showing up in the order books, whether you believe it or not. However this does not apply to Singapore stocks which are easily manipulated.

Keep posting. We need more financial education for the general public. ;-)

Regards,
MM

fishman said...

Hi musicwhiz,

It's being awhile! Hope everything is ging well!

I've thought of this principle before, and agree on the your point that a missed opportunity is especially damaging. This is due to the effect of compounding!

But then again, on hindsight we are all genius. An investor might have invested thinking it was the best available in the market, not realising the opportunity cost.

good entry! do keep it coming!

fishman

musicwhiz said...

Hi MM,

Thanks, yes I agree that everyone can use all the financial education they can get, in order to beat rising costs as well as inflation.

Regards, Musicwhiz

musicwhiz said...

Hi fishman,

Thanks for visiting. Yep hindsight vision is always 20/20, like perfect eyesight ! The problem is that the future is blurry and murky and even a crystal ball may not be able to forsee what's coming up. That is the risk inherent in investing and all investors have to bear.

Regards, Musicwhiz

Derek said...

Hi MW,

Your post really comes in handy. I am thinking if the "buy and hold" strategy is indeed effective and I can't agree with you more on opportunity costs. Many a times I wanted to buy a stock only to see my funds lock up in some useless investments.

I have posted this in my blog to allow more people to learn about investing and to appreciate investors like you who are willing to share your knowledge.

Thanks
Decarn

HH said...

Musicwhiz, Good write-up & reminder for me.

I lost SO MUCH money by buying and HOLDING junk stocks (held since 2000). eg. Creative, popular.. you name it, at -- all time high, yr 2000 :)

Its a heavy price to pay when one does not know the difference between speculation and investment.

musicwhiz said...

Hi Derek,

You're welcome. Yes, opportunity costs can really deprive an investor of a better place to park his money to let it grow.

Regards, Musicwhiz

musicwhiz said...

Hello HH,

Yep, buying at a high usually leaves you with many investments which take a long time to break even. Holding them all the way may not be a good idea too as the opportunity costs are huge; if I had not sold off my Asiapharm and Trek 2000 to buy other more promising companies, my funds would still be stuck in these "under water" companies as their price has never gone back to my purchase price !

Regards, Musicwhiz

la papillion said...

Hi MW,

Yep, I had such stocks that I held at high too. If I didn't sell it back then, I would never have bought into other stocks and subsequently recovered my losses.

Haha, don't we all make such mistakes before? All part of our investing journey.

Chua Meng Seng said...

Hi MW, I used to be buy and hold... and I change strategy... to buy and sell... after "influenced" by my friends ....
ex SGX bought at 1.50 sell and 2.50 (20 lots)
Capitaland bought at 1.20 sold at 4.50 (15 lots)

All never hold due to buy and sell and no study into the company potential in their business....

However, Singpost ... and SPH buy and hold.... offer only the dividend yield ... and little capital gain...


So my view is that buy and hold for long term growth companies .... instead of holding onto steady companies ....

musicwhiz said...

Hi la papillion,

Yes, making mistakes is part of our investing journey. The most important aspect is to learn from our mistakes though, and not to repeat them.

Regards, Musicwhiz

musicwhiz said...

Hi Chua Meng Seng,

Yes, it is always good to research into the company before you buy. This is to prevent yourself from missing any potential upside. If you bought a company very cheaply, someday the dividend yield from the company may well exceed inflation rate by many times, assuming the company continues to grow !

Regards,

Musicwhiz

Anonymous said...

how about one that discusses on the virtues of buy-and-hold?

musicwhiz said...

Dear Anonymous,

The virtues of buy and hold will be when you purchase a good company with strong fundamentals and good growth prospects with a margin of safety.

Regards, Musicwhiz