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For most investors that seek to actively learn about the trade, one piece of advice seems to come up over and over: "invest with a long-term horizon". There are certainly many good reasons for this. For one, it is much easier to see and predict long-term business trends and advantages then it is to predict what is going to happen over the next few months or weeks (in most cases). Investing with a long-term horizon also prevents unwise speculation, avoids paying hefty commissions and taxes, and focuses the stock investor on the business fundamentals - financial health, growth potential, competitive position, price - that are key to finding winning investments.

There is tangible proof that, over the long term, investing in stocks provides the best returns of any investment vehicle. Jeremy Siegel, a Wharton professor and well known financial commentator, showed in his book The Future for Investors (MagicDiligence review) how value-based strategies such as the Dow 10 ("Dogs of the Dow") and dividend re-investment outperform the market over long periods of time. In his other, and more well-known book, Stocks for the Long Run, Siegel goes all the way back to the early 1800's to show how stocks have outperformed bonds and commodities handily over long periods of time. John Bogle, the founder of Vanguard, made his fortune espousing an indexing strategy, showing how over the long run the stock market has provided about 10-12% annual gain on investment (The Little Book of Common Sense Investing is a short, sweet read on his philosophy). No less an authority than Warren Buffett has said that "forever" is his favorite stock holding period.

This wave of evidence and advice have led many investors into the "buy and hold" philosophy, where stock purchases are made with the intention of holding for 5 years or longer. But what is often not said is the risks of following a 5+ year "buy and hold" strategy with stock picks. The purpose of this article is to balance out the popular conception of this strategy of investing - not necessarily to discourage it. So, here are 5 important things to consider before committing to "buy and hold":

1) The Historical Rationale is not Practical

Siegel used a period of 100+ years in his first book, and over 50 years in his second book to justify his claims of indexing or using value based stock strategies for investment. Bogle and his ilk have routinely cited an 80-year average of market returns as justification for buying and holding index funds. These much publicized studies have ingrained in a lot of people's minds that "the stock market returns 10-12% over the long term". That may be true... if your investment horizon is 75 years. For most people, 20-30 years is a more normal period for active investment, and the stock market has returned wildly different annual percentages over any given 20 year period. For the last 20 years, 1989-2009, the S&P has returned about 8.5% after dividends, through both a wild bull and depressing bear market, below the long-term averages. For the 20 years 1962-1982, it returned about 4.5% annually after dividends, not much above the return on fixed assets and well below inflation.

2) Investor Complacency

The psychology of long-term investing is sometimes described as "buy and forget". You do the research, decide that a firm has excellent long-term prospects, buy the stock with the intention of holding indefinitely, and then go do something else. Bad news is blown off because you think "it's okay, I'm in it for the long haul". In the meantime, while you are not looking, your company may be losing significant competitive ground or falling behind in business trends in its industry. The long-term attractiveness of the investment is deteriorating along with the stock price. Former long-term shareholders of mall lynch pins like Montgomery Ward and JC Penney can attest to the damage done to an investment when firms lose touch with trends in the industry.

3) Less Chance to Fix Mistakes

This one is simple. If you are, say, a Magic Formula investor with a 1-year holding period, if you have a losing pick you sell it right before the 1 year is up, take the tax break, and move on, trying to buy a better position for the next year. However, if you are a dedicated long-term holder, and you make a mistake, that mistake is going to cost you gains for several years before you finally get fed up enough with investment losses to sell it. In the meantime, you've not only given up money, but time to earn those losses back. In investing, the miracle of compound interest needs time above all else to work its magic and build you wealth.

4) Holding Overvalued Stocks

On the flip side, another thing that long-term holders do too often is to hold overvalued positions. You buy a great company at a cheap price and within a year are sitting on 50% gains - but the stock is now over-valued. But you don't sell... your favorite holding period is "forever", remember... and the company still has good growth prospects. Thing is, those growth prospects are already priced into the stock. The forward prospects for gains in the investment are not nearly as attractive as they were when you bought. This phenomenon is easily illustrated with almost any tech bell-weather. Take Dell (DELL) for example. You could have done great research and realized Dell's direct selling, low-capital model was a winner back in 1998 and bought in around $20. Your holding would have skyrocketed to nearly $60 by the end of the decade. It was now overvalued, but hey, there were still great growth prospects for low-cost PCs at that point, so you held the position. 10 years later, Dell is selling at just over $15 and you've lost not only your gains but 10 years of compounding interest as well.

5) Start and End is All That Matters

In investing, two things matter: where you start your investment and where you end it. It really doesn't matter what the period in between looks like. If you buy your investment when prices are high and sell when they are low, you get slaughtered no matter how long you held the position (in fact, the shorter the better). If you buy low and sell high, you win, again no matter how long you held. Folks who got caught up in market mania in the late 1990's and piled into index funds (which were highly promoted) have made exactly nothing over the past decade. On the other hand, those who piled cash into the market last winter when panic ruled are sitting on 40% gains in about 8 months. Start and end are all that matters - what is in between doesn't matter nearly as much.

The Point

The point of this article is not to discourage long-term investment horizons or promote short-term ones, but to show that the duration of a stock holding is unimportant as a core strategy. Instead of focusing on how long you plan to hold a stock, focus instead on whether the business is an excellent one and whether the stock is undervalued against past and reasonable estimates of future earnings. If you do this, the gains will take care of themselves.

Consider also looking at Joel Greenblatt's Magic Formula Investing (MFI) strategy. The tenants of this strategy are just as described - find excellent businesses (those with high returns on capital) selling at cheap prices (high earnings yield), and buy them. Hold them for a year, and then refresh with new positions that meet the criteria. This avoids a few problems with the long-term holding strategy, mainly complacency and holding overvalued stocks, all while giving you ample opportunity to fix mistakes with fresh gains. Combining Greenblatt's proven mechanical strategy with the analysis grunt-work provided by MagicDiligence gives you the best chance to vastly outperform the market over any investment career.

Steve owns no position in any stocks discussed in this article.

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Comments

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Posted by cookedc on 2009-10-16 21:02:57

Another case in point is how Buffet admitted a few years ago in an annual letter to shareholders that he would have been better off selling much of his stock holdings in the bubble years of 1999 and early 2000 in stocks like Coca Cola. Even though these were great companies with very good long-term prospects, the stock prices had simply gotten out of hand and thus he should have sold the shares.

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