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.