Sunday, August 12, 2007

Buy and Hold Stock Investing

It is a simple truth that we never know what the markets are going to do on any given day or for that matter over any given week. About the time we think we know, some event occurs that results in a change of direction. We do have quite a lot of historical information, however, and that can give us some clues to how the markets or individual equities may behave. I'll discuss some clues in later articles. For now, though, for example, we know that over extended periods of time markets have risen. That phenomenon supports the "buy and hold" strategy of investing. In the long run, the buy and hold investor seems to have a pretty good chance of success, but of course, as has been said, in the long run, we're dead.

One problem with buy and hold investing is that there is no defined end. Hold until when? As I have often said in my seminars and mentoring: "Hold until death? Great for the heirs, but not necessarily for the initial investor." The pure "buy and hold" investor does not define how long he will hold; it is defined for him. Indeed, he may hold until death and that probably means he had enough money without ever having to tap his investments. On the other hand, he may encounter an emergency and have to sell all or part of his position. In that case, and I suspect that is the more common situation, he is completely at the mercy of the moment. If the investor bought when the market was low and was forced to sell when it was higher, all well and good. But what if he bought at a peak, like QQQQ in early 2000 and had some need to sell in the latter part of 2002. If he bought shares of the Q's around the top in 2000 and sold at the bottom in 2002, he would have lost more than 80% of his investment. Even today, 7 years later, that year 2000 Q's buyer would not be back to even. How do you suppose he currently would feel about his buy and hold investment? That is not to say that over time he may not profit, it is only to say that "buy and hold" has pitfalls as well as any other strategy.

I would never discourage a person from utilizing the "buy and hold" strategy so long as they recognize what they are getting into when they enter the position. They have no exit, period. If they need to exit for some extraneous reason, they are at the whim of the market. For that reason, it seems that money invested in "buy and hold" positions should be money that the investor believes will not be needed for anything in the future. If there is going to be any anticipated need, "buy and hold" needs to be modified in my opinion.

Why sit through the two year plummet of QQQQ and wait more than 7 years for a return to your entry price? I suggest that an exit strategy be set before the position is ever entered. Suppose you decide you want to buy a stock because it has been in an uptrend. You like it because it is moving up. Wouldn't it make sense to determine that you will exit the position when it is no longer in the uptrend. If it breaks the uptrend, it is no longer performing in the way it was when you decided to buy so why hang on? In that situation, when you entered the position you knew you would exit if the stock broke down through the uptrend line. Now all you have to do is buy and hold UNTIL the trend is broken. You have set yourself to cut your losses if the price changes direction and you have kept yourself in gaining more and more profit if the stock price continues to trend up.

Now, you don't have to stay in a bullish position during the downdrafts. What if you really like the company, though? Well, suppose you did get out when it broke down through your uptrend. There is no rule that says you can't buy the same stock down the road. Do you want to continue to hold it if it keeps falling? Get out and wait until it starts back up and repeat the original procedure by buying shares and setting a new exit based on a new uptrend line.

I don't mean to suggest that trend lines are the only way to set exits, but they are a way. Some people may use moving averages or moving average crossovers or crossovers of indicators. Test exit strategies yourself by paper trading and see what works best for you. The bottom line, for me, is to adopt a buy and hold strategy, but for each trade define the "hold 'til when" exit strategy using something other than undefined time.

Bill Kraft, Editor
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