Buy & Hold Strategy Doesn't Work
The buy and hold strategy is the idea that if you buy an investment and hold onto it for a long period of time, you will make money in the long run. Especially if you are buying low cost, broad market index funds. The market will have its ups and downs. It will make a lot of noise. However, if you consistently buy and hold for a longer period of time, your investment will grow and so will your wealth. However, there is a simple flaw to this strategy that too many of us overlook.
You and I.
Buy and hold strategy doesn’t work because we get in our own way. Normal human beings are far from fully rational and stock market investors are no different. Just think of all the people we know. Our friends, co-workers, supervisors, our kids. Do any of us act rationally? Of course not. We know we shouldn't eat that third Twinkie, because it could lead to diabetes and diabetes will kill us one day. I know this because that is what my doctor told me. But I am an irrational being. So I succumb to my temptation and eat that Twinkie.
Buy and hold strategy is an excellent strategy to grow our wealth, but when we keep getting in the way, we prevent it from working its magic. Let me talk about four common behavioral financial principles that keep us from winning with this strategy.
01 - Overconfidence
Our tendency to be overconfident about our beliefs and abilities, and overly optimistic about assessments of the future. Let’s consider our own assessment of our driving skills to highlight this bias of overconfidence.
Driving a car clearly requires some level of skill to do well. We don’t just let anybody drive a 1,000 pound machine, 70 miles per hour down a speeding freeway. You have to pass a written test, a hands-on drivers test and wait 3 hours in line at the DMV to earn this privilege.
And even after all these tests, not everyone can be an excellent driver. Based on statistics, half of us are better than average and half of us are worse than average. There are a small percentage of really excellent drivers and a similar small percentage of really horrible drivers. It’s a basic bell curve. However, how do you think an average person would answer if asked about their driving skills? Do we objectively know where we stand on the bell curve?
To answer this question, there once was an experiment that asked a group of individuals their competence as drivers in relation to everyone else who drives a car. As you can obviously guess at this point, about 80 to 90 percent of respondents said that they were more skillful, safer drivers than others on the road. What these kinds of studies show is that most people consider themselves above average, when the reality is that this isn’t true for most of us.
I do this constantly in order to not fall into a depressive mood. I have to constantly tell myself that my youtube videos are above average. Because the truth hurts too much.
Imagine how this overconfidence plays out in the investment world. When we think we are better than average, many people mistakenly convince themselves that they can beat the market. Just like Warren Buffet, and just like Peter Lynch. I’m a fairly smart person, so if I read enough news and company financials, I can control the outcome. I can identify winning stocks and make millions overnight.
This kind of overconfidence leads us to speculate more than we should and as a result, we trade too much. Trying to dance in and out of the market. Buying low and selling high. Unfortunately studies have shown that the more individuals that traded, the worse he or she did.
Buy and hold only works when we as the strategy suggests, we buy and actually hold. For a long period of time without tinkering with our investments. But overconfidence can get in the way of this strategy and sabotage our future wealth.
02 - Biased Judgment
Psychologists have long identified a tendency for individuals to be fooled by the illusion that we have some control over situations we are in, in fact, when none exists. In one study, subjects were seated in front of a computer screen divided by a horizontal line, with a ball fluctuating randomly between two halves. Then people were given a device to press to move the ball upward, but they were warned that random shocks would also influence the ball so that they did not have complete control.
Subjects were then asked to play a game with the object of keeping the ball in the upper half of the screen as long as possible. In one set of experiments, the device was not even connected to the computer, so the players had absolutely no control over the movements of the ball. Nevertheless, when subjects were questioned after a period of playing the game, they were convinced that they had a good deal of control over the movement of the ball.
Remember, for some the device wasn’t even connected to the computer so their activity had absolutely no influence on the outcome of the ball. Yet, people believed they did. Biased Judgment. In the same way, this illusion of control often leads investors to see trends that do not exist or to believe that they can spot a stock-price pattern that will predict future prices.
The truth is that despite considerable effort to glean some form of predictability out of stock data, the fluctuation of the stock price is oftentime close to random rather than predictable logic. Price changes in the future are essentially unrelated to changes in the past. They move because of the latest gossip. Or because of fear. Or even manipulation by a group of stock investors. The reality is that it’s impossible to predict.
This biased judgment, the illusion that we have some control over situations where none exists, accounts for investors to chase hot funds or extrapolate things they think they see from recent events. If we want to win with a buy and hold investing strategy, we have to be careful to check our own bias. We have much less control than we think, especially when it comes to the market. So the best strategy is really to trust the process and not do anything but be patient in times of market volatility.
03 - Herd Mentality
Have you ever seen a study where a single person stood on a street corner and looked up at an empty sky for sixty seconds? Initially a small fraction of the pedestrians on the street would stop to see what the person was looking at, but most would simply walk past.
Herd Mentality
But when about five or so people started to look up at the sky, about more people would stop to gaze at the empty sky. And when this number grew to 15 or more people, more than half the people walking by would stop and look up. Higher the number of people looking skyward, more people would stop to look up.
This simply is the herd mentality and I’m sure many of us have done the same without having thought about twice. You saw a crowd of people gathering up for something and before you know it, you are part of the crowd.
The internet bubble of the 1999 and early 2000 period provides a classic example of herd mentality in the investment world. Individual investors were excited by the prospect of huge gains from stocks catering to the internet economy and got infected with the herd mentality.
People everywhere were talking about how great wealth was being created by the growth of the internet and if you didn’t want to be left behind, you had to get into the action now.
Individual investors and even institutional investors were purchasing internet stocks for no other reason than that prices were rising and other people were making money. Even when the company had no income, no business plan or a viable product. Just the fact that they had a ‘.com’ at the end of their company name made them a prime target for investments.
And just when we thought we all learned a good lesson, the same thing happened during the US housing bubble of 2008 and 2009. In the years leading up to the housing crisis, fueled by easy credit, house prices began to rise rapidly. The initial rise in prices encouraged even more buyers. Everyone was talking about how they were making tons of money through real estate because house prices appeared consistently to go up. Many, fueled by the herd mentality and greed to get rich overnight, were flipping houses to make quick dollars.
We know how both the internet bubble and the housing bubble ended. Not very well for all that followed the herd. A key way to win with the buy and hold strategy is not to get swept up by the herd mentality. Herd mentality can easily drive the market up artificially and it's easy to get blinded by greed.
“Be fearful when others are greedy and greedy when others are fearful.” - Warren Buffet
04 - Loss Aversion
Loss aversion is a cognitive bias that describes the pain of losing is psychologically twice as powerful as the pleasure of gaining. Even when the scale of the loss or gain is identical. For example, let’s say that you are told that a fair coin will be flipped and that if it comes up heads you will be given $100. If the coin comes up tails, however, you must pay $100. Would you accept such a gamble?
Most people would actually say no. Even though the gamble is a fair one in the sense that in repeated trials you would end up even. Half the time you would gain $100 and half the time you would lose $100. Psychologically we have a harder time digesting the loss of $100, despite the same probability that we could make a $100. The reluctance to take losses is non-optimal when it comes to our investments.
Risk is a necessary cost to investing in the market. Risk comes with a lot of volatility, a lot of ups and downs. And this is the price you have to pay if you want to play in the market and have a chance at growing your net worth.
However, people who are very prone to risk aversion might prefer to avoid risk altogether. Leading to overly conservative portfolios that do not deliver the returns they need to achieve their goals. When it comes to investing, a general rule of thumb you want to understand is the relationship between risk and reward and how it correlates to stocks and bonds.
If you want to take more risks with your portfolio, you want to hold more stocks. If you want to take less risk, then you want to hold more bonds. But, when you take less risk, there are also less rewards - meaning potential for high returns. Take a look at the following chart from the Bogleheads Guide to Investing.
Source: The Bogleheads Guide to Investing
This chart shows maximum annual loss and the average annual return an investor would have incurred during the period from 1926 to 2012 based on various stock to bond allocation. If you were to have been 100% in stocks, though your average returns would have been the highest at 10%, at your worst year, your portfolio would have lost 43% of its value. Imagine if you were about to retire and your portfolio just dipped by almost half its value. You’d either need to push back your retirement or have a heart attack. Maybe a combination of both.
Now imagine that you are very risk averse, so you decided to go 100% bond. Ok, so you are protected from the worst annual loss to just 8%. But, your average return is only 5.5%. By being so risk averse, you missed out on much of the gains from the market by having an overly conservative portfolio. Or worse, it can also push you to sell during a stock market downturn simply to avoid further losses—which could mean you miss out on gains when the stocks they have sold rebound.
The bottom line is that buy and hold strategy works. But only if we can overcome our bias of loss aversion and avoid our own self from getting in the way.
