This is the second in a new series of posts, where we're looking at gauging the stock market's direction. In this post we'll look at a 'buy and hold' investment strategy and discuss whether this approach is broken.
If you would like to know more, please just download our free report How to Gauge Stock Market Direction.
What is 'buy and hold'?
Buy and hold is an investment strategy that only tends to work in long-term upward trending markets, such as the super bull market that occurred between 1980 and the year 2000. Unfortunately, the market does not always go up, as many investors have experienced over the last twelve years.
And if you did decide to take a buy and hold approach, you still have the difficult task of correctly timing your initial buy. A buy and hold strategy may work, but only if you buy when the market is low and just before a bull market begins. But what about during bear markets? Adhering to a buy and hold program during significant correction periods can be very painful, particularly if retirement is approaching.
Why we prefer strategic timing
Another reason why we prefer strategic timing is because every buy and hold program has to start with an initial buy. You have to decide when to get in and if your decision is based on emotions, which it usually is, you may encounter problems. For example, if you had used a buy and hold strategy and bought at the peak of 2000, just before the 2000–2002 savage bear market, or at the 2007 top, just before the 2007–2009 financial crisis, you may have experienced losses of 50–90%.
Dropping 50% requires a 100% gain to get you back to even. In the 2000–2002 bear market, our ISA account dropped 27.3%, which was pretty good when you consider that the FTSE 100 over the same period made a loss of 43.2%. The NASDAQ Composite did even worse, imploding by 67.2%.
However, in the most recent bear market of 2007 to 2009, we weren’t so lucky. In 2008, the FTSE 100 fell 31.3%, the NASDAQ tumbled 40.5% and our account sunk by 42.3%. Fortunately, our portfolio rebounded strongly – we made a 56.4% gain in 2009 and 27.2% in 2010, which helped to make the loss back quickly.
But others who experienced significant losses during 2008 won’t have been as lucky. Some investors who took heavy falls will be sitting in those losses for up to a decade. Imagine what it must be like for those investors who took a loss of 90% in either of those two bear markets. For them it would mean their portfolio having to rise 900% to get back to where they started. That could take some time! The table explains how this works.
This is why it is so important for you to try to preserve your capital and get out of the market and into the safety of cash when you see the first signs that the market has changed from healthy to unhealthy.
Most investors buy at the wrong time
You might be thinking that you’d have to be extremely unlucky to buy right at the top of the market, however, as you will soon see, unfortunately most investors do buy at the wrong time. The perfect point to start a buy and hold program is right at the bottom of the market and the point to exit would be right at the top.
The challenge we all face is that when the market is at its bottom, not many people feel like starting their buy and hold program. Most investors want to start their buy and hold strategy when the market is at its top – again because of how they feel. Unfortunately, all too often investors are influenced by short-term market movements rather than focusing on the longer term trend.
As the chart illustrates, many investors go through a range of emotions at different points in a market cycle. All too often this can result in them entering or exiting the market at precisely the wrong time.
As markets peak, investors experience emotions of excitement, thrill and euphoria. This tempts unsuspecting buy and hold investors to start their programs when the market is highly priced. But, as markets dip, negative emotions of panic, despondency and depression lead buy and hold investors to give up on their plan, exit the market and realise a loss.
Buying high and selling low
To support this theory, the next chart shows historic net investment flows (investment purchases minus investment sales by retail clients) into equity funds by UK investors, alongside movements of the FTSE 100 Index, between 1992 and 2009.
As can be seen, investment flows increase significantly as markets peak, especially during P1 in 2000 and P3 in 2006/2007, and conversely decrease during market dips, especially during P2 in 2002 and P4 in 2008, when we see net outflows (i.e. more sales than purchases by investors) from funds.
Next week, in the third post in this series, we'll look at a real life example of the dangers of 'buy and hold'.
Remember, if you would like to know more, please just download our free report How to Gauge Stock Market Direction.
As always, if you have any questions or thoughts on the points covered in this post, please leave a comment below or connect with us @ISACO_ on Twitter.
ISACO specialises in ISA and SIPP Investment and is the pioneer of ‘Shadow Investment’; an easy way to grow your ISA and SIPP at low cost. Together with our clients, we have an estimated £57 million actively invested in ISAs and pensions*. Clients like us because we have a great track record of ‘beating’ the FTSE 100**. Over the last 16 years, we’ve outperformed the Footsie by 60.2% and over the last 5 years, we’ve averaged 14.5% each year versus the FTSE 100’s 8.8%. You can find us at www.ISACO.co.uk.
What is Shadow Investment?
Picking the right fund for your ISA and SIPP is not exactly the easiest job in the world. And knowing 'when' to buy and 'when' to exit is even more difficult! Our ‘Shadow Investment’ Service is here to help. Our service allows you to look over our shoulder and buy the same funds that we are buying.
When we are thinking of buying a fund, we alert you so that you have the opportunity to buy it on the same day that we buy it. We also tell you about when we are planning to exit the fund. You control your investment account, not us. You can start small and invest as little or as much money as you like.
By knowing what we are buying, when we are buying and when we are exiting, throughout the year you can mirror our movements and in effect replicate our trades. This means you have the opportunity to benefit from exactly the same investment returns that we get. Our investment aims are 10–12% per year.
We are totally independent, fully transparent and FCA compliant. We’re warm, friendly and highly responsive and it’s a very personal service that gives you direct access to the Sutherland brothers; ISACO’s two founders.
Who are ISACO’s clients?
Clients who benefit most from our service have over £250,000 actively invested and the majority of them are wealthy retirees, business owners, self-employed professionals and corporate executives. We also have clients from the financial services sector, such as IFAs and wealth managers.
Do you have questions?
To have all your questions answered, call 0800 170 7750 or email us at: info@ISACO.co.uk.
*November 15th 2012: Internal estimation of total ISA and pension assets owned by ISACO Investment Team and ISACO premium clients.
**Long-term performance: December 31st 1997 - December 31st 2013 ISACO 91.3%, FTSE 100 31.1%. 5 year performance: December 31st 2008 - December 31st 2013. ISACO Investment performance verified by Independent Executives Ltd.