The Death of the ‘Buy & Hold’ Investor!

As this will be my last posting for 2008, I would like to express my thanks to all of you who have read and contributed to my blog. This was a new venture for me, and I am pleased to say it has been great fun and very successful. We have had in excess of 10,000 ‘hits’ to the site after just 9 weeks of ‘blogging’. I hope that the topics I have been posting have been able to assist you in some small way in your education and your trading and investing endeavours. The idea being that this blog can be a continual reference point, allowing you to refer back to the various topics in the months and years ahead. We certainly have some exciting projects in the pipeline for 2009. This blog site is definitely one of those and I will be back in mid-January for my regular weekly comment on various aspects of the market and trading and investing in general.

Like all years, 2009 will be different from all others. It will present challenges and exciting prospects and opportunities to all of us in various ways. It will reward the prepared and educated traders and investors, and frustrate those who are unprepared. Those that have a solid plan in place for engaging or perhaps re-engaging the market when the time is right, will be ready and able to take advantage of the opportunities as and when they present themselves. Those that don’t have a plan in place, or those that are sitting on portfolio’s that have lost a significant portion of their value, and are waiting patiently for the market to resume it’s uptrend, probably won’t participate in the opportunities through fear, a belief that money can’t be made in the market, or both.

The ‘buy and hold’ strategy employed by many equity investors over recent years during the bull market has proved disastrous as the market has collapsed. They have been left holding stocks that have collapsed in price, as the underlying businesses have imploded. With no clearly defined exit strategy or portfolio exposure minimisation strategy, they have simply sat and watched as their capital has eroded in line with downward pressure on share prices. Many of these investors are down in excess of 50%. I know of one so called ‘buy and hold’ investor with a significant parcel of RIO shares in his portfolio. The price of RIO has collapsed from a high of just short of $160.00 per share in May of this year, to around $40.00 today – and, he still has them in his portfolio!

He has not only suffered a huge reduction in the value of his portfolio, but has foregone a huge profit on the ‘trade’ through not having a clearly defined exit strategy in place. A compounding investment error is having too much of his portfolio in a single stock; we call this a money management error. In addition, the opportunity cost of not having banked the profit or limited the loss is enormous. Just think of what he could do with all the lost profit from that trade when the market once again presents us with buy signals! Instead, he is locked into a dud position with his fingers crossed while he waits for the market to return to the levels we saw in late 2007/early 2008.

Needless to say, he was NOT a SPA3 user. If he had been, he would have had clear and unambiguous sell signals provided by the SPA3 system, and would have been able to exit the trade, bank the profit or limit losses, and participate in new buy signals as and when they present themselves, starting again from a far higher capital base.

This is just a single stock without leverage through, say, a margin lending facility! Bring leverage into the equation across a number of stocks and the picture is far worse.

The majority of people in these and similar positions have little or no plan for engaging the market. Their buying decisions are loosely based on fundamental analysis, news stories, broker ‘advice’, newsletters, or hot tips from a mate, and do OK during a rampaging bull market, such as the one we experienced up until the end of 2007. But when the bull market ends and the bears gain control, these “punters” have no defined point at which to exit or lighten their positions.

Many also engage in another silly activity – that of averaging down! Instead of cutting their losses they fall for the age old trap of buying more because the price is now cheap. If the stock was a good deal at $10.00 per share, it must be an even better deal at $5.00, and then again at $2.00. They then watch as the market smashes their beloved share even further and they are left holding a worthless stock as a long term investment. The outcome of averaging down is increasing your exposure in a stock that is trending down! You should only do the exact opposite! Averaging down is predicated on the myth that all stocks will eventually go up again. Firstly, this is a total unknown amd mostly untrue and secondly, if they ever do, when?

Put simply, buy and hold strategies, don’t work over the long term. All it needs is a market reset such as has occurred with too much exposure to the wrong stocks or too much leverage – at the wrong time of your investing career – and your portfolio may never recover. Many have said it is “time in the market”. I have always disagreed. It is “time in the market” and “timing the market”.

The monthly log chart of the S&P500 shows a 20 year bull market followed by a 17 year sideways market then followed by a 17 year bull market. The S&P500 has been moving sideways now for nearly 9 years. Both sideways markets have had 50% or near 50% bear markets and 60%+ bull markets during the long term secular sideways movement. It may be many years before equity market indices make new highs that lend themselves to the buy and hold strategy again, as buy and hold strategies ONLY work in secular bull markets such as those from the mid 1940’s to the mid 1960’s and the late 1982 to early 2000 bull market. Active investment strategies will work in both long term secular bull markets and long term secular bear markets that mostly go sideways over many years. Why take the chance with a buy and hold strategy? Can your portfolio afford to move sideways with the market for many years to come if the sideways market continues for another 8 – 10 years?

Actively managed portfolio’s with a clear strategy for undertaking ALL buy and sell decisions that has an edge will always outperform the overall market and the buy and hold investor provided that the actively managed portfolio is sufficiently capitalised. SPA3 has proven this. The SPA3 strategy with hedging has managed to achieve 22.6% compounded per annum (or 402% total profit after brokerage pre tax) since January 2001 to current whilst the ALL-ORDS has managed just 1% compounded per annum (or 7.6% total profit), that is, sideways movement for nearly 8 years.

Mechanical traders and investors know that their system has a clearly defined and measurably EDGE in the market, combined with a strict set of trading rules and processes for engaging the market with confidence and consistency. They also employ strict money management and risk management that they adhere to at all times. In essence they know what to do, when to do it, and how much of it to do. They have minimal emotional involvement with their trades (unlike our friend above with the RIO shares) – they have developed a portfolio mindset (as we discussed in an earlier blog ), make minimal trading errors and they have developed the ability to execute all trades with a Traders Mindset (as discussed in last week’s blog).

I mentioned brokerage above. Active investment strategies in equities were impossible to to deploy up until the mid 1990’s because the minimum borkerage rates were too high to actively trade. Stock prices, on average, did and do not move enough over a 2 – 4 month period to cover 2.5% each way brokerage rates. With minimum brokerage rates below $20 or 0.11% the era of actively managing portfolios was born. Couple this with the availability of investing tools and the 52% retracement of equity markets in 2008 the buy and hold investment strategy may go the way of the dinosaurs.

What will the market do in 2009? Who knows! The most important question is – “Will you be ready to participate when it does turn and the next uptrend begins?” Will you be prepared and confident and not only know what to do but to do what you know? Or will you still knee-jerk react by randomly selecting stocks based on news stories, fundamental analysis, brokers advice, newsletters, or some unresearched set of technical indicators? The key to success is to learn from the mistakes of the past, educate yourself, be prepared, and know exactly what to do next time. Employ a proven, mechanical trading strategy, like SPA3, and begin trading and investing in a professional manner using a proven strategy and processes with a clearly defined and measurable edge in the market. Doing the same thing that you have always done will result in the same outcomes.

My wish for 2009 is for all the buy and hold and leveraged investors out there to learn from their mistakes, shift their investing paradigm, re-educate themselves and employ a proven trading system with well defined risk management processes for all their trading and investing. This way the market can throw whatever it likes at you and you will be prepared.

I wish everyone a Merry Christmas and a safe, happy and prosperous 2009.