Saturday, July 18, 2009

Risks of Buy and Hold

In the article last weekend, I discussed the concept of trying to catch falling knives and, quite predictably, I received some comments from readers justifying their own actions in buying falling stocks. One contributor set forth a very thoughtful plan through which he buys falling stocks with which he has had success, but was careful to note that the strategy is very risky. I agree completely and commend him for the construction and use of his plan that is set out in last week's blog. Another commentator defended his practice of buying GE as it was falling on the theory that it is a great company. I have a little more trouble with that one and liken it to a fellow who was upset with me a couple of years ago when I criticized elements of buy and hold because he and his family had been holding what he referred to as "that old doggie" Citigroup (C) since it was only $14. Citigroup is trading under $3 as I write this article.

First, I want to say that I have no problem with people trading GE. It is, indeed, a great company, and even in very significant downtrends such as GE has experienced in its fall from about $37.50 last year to its current level under $12, there have been several trading opportunities both to the upside and the downside. The key, in my view, is to have an exit strategy in place since we can always be wrong on direction. We also need to be mindful that GE, though a great company, has not been a great stock over the last 9 years. It traded near $60 in 2000 and if I had bought it then and held it until now, I don't think I would be very happy. It is not alone. Other great companies like Coca Cola (KO) have seen significant drops over that time as well. If a buy and hold advocate just bought the Dow near the high in 2000 he would be down approximately 3400 points as I write today.

The point I am trying to make is that a buy and hold approach with no exit strategy is extremely risky. To start, buying a stock is one of the riskiest things we can do in the market because, without stops or protective puts or some hedge, the risk is the whole investment. Great companies have failed and disappeared. There was a time when investors would have laughed at the suggestion that the great Pennsylvania Railroad could ever fail, but I watched as my own father, then a Federal District Court Judge, signed Order No. 1 in the Pennsylvania Railroad bankruptcy proceeding. Bankruptcy of General Motors was unthinkable not so long ago but we just saw it happen. The list of once great companies that failed is long, indeed. Those who were buyers and holders of those companies doubtlessly suffered. According to "Yahoo answers" American companies have been going into bankruptcy at a rate of 500 a week! Obviously most of those are not publicly traded, but publicly traded companies like GM definitely are to the great pain of shareholders.

I have little doubt that many will remain unconvinced, but buy and forget or buy and hold with no exit strategy is fraught with great danger. What if we bought at a top and have need for the money when there is a significant decline such as the one we have recently been witnessing or the one following the 2000 high? My suggestion to the buy and hold investor is to be aware that there is risk, sometimes enormous risk, and ask yourself the question: Hold until when? Why would you not want to have an exit strategy? If you exit and then the stock turns back up, you can always buy it again. Sure you may have to pay a capital gains tax (currently at a low rate) on the gain, but isn't it better to do that than to see your investment go down the tubes completely or suffer a large loss?

by Bill Kraft, Editor
Copyright 2009, Makin' Hay, Inc.
All Rights Reserved

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To comment on Bill's article click on the "comments" link below.


Shankar said...

I am regular reader of your excellent briefs on stocks.

This article is an eye opener particularly investors who think good stocks never go down but we all should agree anything is possible. Therefore I fully agree with your advice of exit strategy and thanks for this excellent article.


Thomas said...

To some extent you are knocking down a straw man. If anyone were to follow the "buy and hold" strategy literally, he would certainly be risking his entire investment, and surely one must have an exit strategy. But I believe the maxim is intended to be be used prudently: One's (diversified) portfolio ought to be held for the long run, with the caveat that stocks should not be permitted to decline more than x%. Yet the overall strategy of buying for the long run and ignoring the minor ups and downs has considerable merit, and helps one avoid frivolous and counterproductive entrances and exits to the market. Not a trading strategy, but a workable strategy nevertheless, used in such a fashion.

Anonymous said...

One of the really useful insights I received from you (among many, many useful, valuable insights) is the idea of always having an exit plan for every position held. This includes purchases that one hopes will be long-term holds.

In addition, your wise advice applies to day trading. In the past few weeks I've been doing a bit of day trading in my IRA. Thanks to what I learned from you about always having a clear, near exit I've managed to take out some nice profits, including from that "falling knife" GE. Example: by following your charting guidelines, I made 4.71% on a quickie GE day trade on 7/17/09. I also made a tiny profit on a GE put in my taxable account.

For the record, thanks to what you've taught me, I never buy anything UNLESS I see a near, clear exit.

~ Gemma Star

Russ said...

I read your column regularly for the useful advice you always give. Therefore I can not understand how anyone can argue with having an exit strategy.
After reading "Trade Your Way to Wealth" I implmented a couple of your strategies and have had success and a few losses. Without heeding your advice to have an exit strategy, I would have lost more. I feel I need to mention having an exit strategy should also include where to put the exit in relation to a stocks volatility. Just this week I was having success with an Apple option, but I placed my stop to tight which whipsawed me out and I missed a good portion of the profit.
I have only begun reading "The Smart Investors Money Machine" and already I appreciate your genuine interest to teach others. Keep up the good work.


Bill Kraft, said...

Thanks for writing Shankar. I appreciate your kind comments.
Bill Kraft

Bill Kraft, said...

Indeed, Thomas, that is the point. However, there are many who do follow the buy and hold strategy literally. Anyone my age can attest that for many years that is EXACTLY what brokers counseled and it is EXACTLY what a high percentage of investors did. I am in almost daily contact with investors from many corners of the world and I can tell you it is still what many do so I really don't think it is a straw man. It is reality for a lot of people even though you, quite rightly in my view, are not numbered among them.
Bill Kraft

Bill Kraft, said...

That's great to hear, Gemma Star! I'm glad you are utilizing a method that fits your style and is working for you.
Bill Kraft

Bill Kraft, said...

Many thanks, Russ. I'm glad you have had successes in both achieving profits and in cutting losses. While I definitely advocate setting exits, I hasten to add that setting stops can be one of the most difficult decisions we make since where we set the stop is quite subjective. In my experience, setting good stops that avoid whipsaws most of the time is more art than science. When I have a stop that is hit, I often continue to watch the price movement and if it turns back the way I had originally played I get back into the position. I once had a very good trader tell me that many times a successful trader will get whipsawed two, three, or even four times before his trade ultimately meets with success. I also want to tell you that I genuinely appreciate your kind words about my books.
Bill Kraft

empiremack said...

Thanks Bill, You know your strategy. I started out a Buy and Hold investor until I saw my gains disapear with every bit of bad news. So I resorted to sell at a loss and reinvest in a more productive stock(lack of an well thought out EXIT plan. I recently bought GE at $10+ for the long but sold on GE's own 2010 predictions of continued losses. Is news of a certain stock an effective exit plan? THANKS for all your past and future posts. Mack

Anonymous said...


The problem is complacency. People
get in that rut in all aspects of life. I fermently agree. It seems like common sense to have a plan to exit. Always have other options waiting in case disaster strikes. More often than not, the writings on the wall.

Thanks for your insight,


Bill Kraft, said...

Thank you for writing, Mack. Your question about news as a possible exit is an important one. Undoubtedly you are familiar with the old saw "buy on the rumor, sell on the news." That adage suggests that the rumor causes excitement and often buying moving the stock price up, but once the news is announced, there is no longer anything to speculate about so the excitement wanes. I believe that is one reason why we so often see a stock price dip even on a decent, if not great, earnings announcement. For the fundamental trader or investor, though, news could definitely be a reason to exit or enter a play.
Bill Kraft

Bill Kraft, said...

Thanks, Shannon. Complacency may be one of the biggest impediments for the investor while fear and greed probably top the list for traders.
Bill Kraft

Anonymous said...

Thank you gor your excellent articles - please keep up your good work.

I was a part swing trader and a part buy-and-hold guy. Now my philosophy is to NEVER buy-and-hold but ALWAYS Swing/Day trade. Why? Because Corporate America, like its political counterpart, is run buy crooks who have their own selfish interest in mind. Sadly, this is true eveb for "good ol' solid companies". As you pointed out, who would have believed C selling under a dollar, Bank of America at 3? And there again, the government helping them to hide the toxic assets by removing the M2M rule?

In short, the playing field is NOT level. The traders at a tremendous disadvantage vis-a-vis the Money Managers and Corporate Rulers. What you see is NOT what you get!!! It is a time of Caveat Emptor (buyer Beware). Careful what you trade and as soon as your objective is met, get rid of it.

Buy and hold is sucidial with scumbags in power. With scoundrels running corporate America and incompetent monkeys monitoring them, a trader has nobody to rely on save his/her on smarts.

Those who buy-and-hold even if correct, lose on the swings where there could have reaped greater profits going in-and-out of trades.

Word of advice to those who plan to buy and put the share certificate in a lock box and foget about it (as Finance Advisors woudl advise), I say make sure you buy a good insurance to cover your funeral.

Good luck to all!

Anonymous said...

Bill. After markets have fallen, and great losses for many, you conveniently post mortem the risks of buy/hold abd falling knives. You also mention currently extremely bearish chart formations. At you can click on Galley Views of the major market charts. In particular, the weekly charts for the past 3 years are very revealing of market trends. The NASDAQ shows a clear double bottom for the long term and the S&P and`the DOW show a whopping reverse head and shoulders breaking the neckline in bullish fashion. The Hang Seng is bullish after a re-tracement from the huge recent rally. What in the world are you talking about? Big time inflation is in the cards for the future. The markets reflect this by moving up, not down. Do not mislead your naive readers. Thank you.

Bill Kraft, said...

Strong words, Anonymous, but most unfortunately we have seen that there has been some truth in your conclusions.
Bill Kraft

Bill Kraft, said...

Anonymous, the last thing I would want to do is mislead my readers. Had you read my book, "Trade Your Way to Wealth," and my articles over the PAST SEVERAL YEARS, perhaps you would not have been so demeaning in your approach. I have been writing and lecturing on the dangers of buy and hold for years. Sometimes it is better to know what you are talking about before becoming accusatory.
Bill Kraft

Michael Loren said...

Bill, I am reading Trading your way to Wealth and I have been sorting out how to diminish risk. You have a lot of great ideas.. especially how risky it is buying individual stocks. I'm leaning toward ETF's and although I don't have alot of time to trade stocks, I am following a strategy of buying a ETF in stages especially with down markets and diminishing my holding during upmarkets. Currently I am sitting on more cash than I would like, but this market is not going down. thanks for your blogs, they are good motivational pieces.

Bill Kraft, said...

Michael, you're welcome and thanks for writing. One statement you made deserves a little comment I think. You wrote: "...but this market is not going down." I would only add "so far." I do like an ETF strategy since it reduces the risk of individual stocks. For example, if the CEO of a company gets locked up, we can expect a fairly dramatic dip while the ETF that contains that stock would probably not have as severe a reaction since the ETF holds a basket of stocks. Of course, the opposite is true. If the individual stock takes off, we would not necessarily expect the ETF to move as far or as fast.
Bill Kraft