"Buy and Hold"?

Is "Buy and Hold" Dead?

Financial experts have traditionally held that equities belong in a portfolio because, despite involving greater risk than cash or bonds, when held over the long term they offer higher return potential. However, that conventional wisdom has come under fire since the double whammy of the dot-com crash and the credit crunch. If you're wondering whether it's time to revisit the amount you've allocated to stocks, understanding both sides of the argument can help you make a more informed decision.

A challenge to the case for equities

Much of the discussion in financial circles has centered on two factors. Until last year, the S&P 500 hadn't experienced negative returns over a 10-year period since 1939. However, in 2008 the annualized return on the S&P 500 for the previous 10 years turned negative; as of last December, the S&P's compound annual return for 1999-2008 was -1.38%--less than the 3.22% of U.S. Treasury bills.

Also, a widely discussed article by financial analyst Rob Arnott (Journal of Indexes, May/June 2009) argued that rolling over 20-year Treasury bonds and reinvesting the income would have outperformed the S&P 500 for an even longer period, from 1969 to 2009.

Questioning the questions

Though it's true that stocks have experienced a lot of volatility in the last decade while bonds had an exceptionally good run during the period examined in Arnott's research, it's never been more important to remember that past performance is no guarantee of future results.

Opponents of Arnott's arguments contend that the conditions that produced the cited outperformance by bonds can't be counted on to happen again. Interest rates have declined substantially since the early 1980s, which helped push up bond prices. Not only are Treasury yields relatively low--bond yields move in the opposite direction from prices--but the Federal Reserve is working overtime to try to keep them that way. That means the conditions that created a favorable environment for bonds may not continue in the future. If and when interest rates and inflation start heading up, they are likely to affect bond prices.

It's also instructive to look at the period just after 1939, the last time the S&P 500's 10-year return was negative. In 1940, the compound annual return for the previous 10 years was 1.8%. A year later it went to 6.43%, and by 1942, it was 9.35%--not far below the overall historical annual average of 9.62% since 1926.

Finally, even though the large-cap S&P 500's 10-year return was negative as of December 2008, the 10-year average for small caps was 6.44% over the same period.

The smart way to buy and hold

Even if you shouldn't expect stocks always to outperform bonds--and there's no guarantee either way--that simply underscores the value of investing in multiple asset classes. Diversification can't guarantee a profit or insure against a potential loss; not one of the 16 asset classes Arnott discusses had a positive return in September/October 2008. However, the very idea that you can't be sure which type of investment may outperform others should demonstrate diversification's value. What if the asset class you expect to provide higher returns isn't the best performer during your time frame?

Investing is rarely black and white. You might decide to have a core holding and be more tactical with a portion of your portfolio. And even if you are firmly in the buy-and-hold camp, that shouldn't be the same as "buy and forget about." Monitor your investments periodically to ensure that they're still appropriate.

Market data source: Ibbotson SBBI