The All-American Buy-and-Hold Investing Scam

Since I was a boy in the 1950s/60s, even long before, the public has been indoctrinated by Wall Street and the financial press to believe that there is one, and only one, method of investing that works: buy stocks for the long haul and hold on to them no matter what, through thick and thin in the expectation that the stocks will appreciate in value. When right, and sometimes they are right, investors reap the benefits and create wealth. So at least goes the theory. This is the buy-and-hold school of investing. While it has worked for some investors over the decades, it has failed many others. Luck plays a great role – too great – in success or lack of it.

How many people do you know who have, by dint of regular, long-term investing, grown a large and valuable portfolio – achieved wealth by holding on to those stocks? You probably know a few. I do. There’s Warren Buffett, but where you and I might buy a pipeline stock, he buys a pipeline company; not quite the same thing. But do you know anyone who has lost money, perhaps a lot of money, in the stock market? I know many more of those, and they stay far away from investing!

You’ve probably heard the old saying that the way to make a small fortune in the stock market is to invest a large fortune. Another great one is that the most difficult time to invest is always now. Mark Twain famously considered every month of the year “peculiarly dangerous” for investing in stocks. And there’s my favorite… Wall Street: a thoroughfare that begins in a graveyard and ends in a river.

If long-term investing is such a cinch, if every Mom and Pop can do it successfully – nay, easily – why do we have sayings like that? The reason is that it’s not so easy. Insiders with vastly superior information play games on a field where they hold insurmountable advantages. Jim Cramer laughed on-camera in 2006 about how easily stocks are (and should be) manipulated by on-the-ball money managers.

This is why I refer to the old buy-and-hold strategy as buy and hope; those practicing it tie up their valuable capital for long periods of time, hoping for large gains in the future. But the system is not geared that way, and when buy-and-hope works, it is often as not purely fortuitous.

I have some fundamental problems with the buy-and-hold strategy:

  1. Sorry: Stocks don’t always go up.

A lot of people (everyone’s Aunt Mabel, for instance) tend to buy stocks at the end of a bull market, after listening to feverish bull market stories for years, only to later watch them fall for years through a bear market. The B&H proponents say not to worry when the market turns down; just hold onto those stocks, because market dips are transient things. Well, transient may be years. If you are 30 years old, maybe this is not a concern. But if you are approaching – or worse, in or past – middle age, do you have time to wait out secular bear markets?

The market last century went up an average of 9% a year approximately. But that is an average. There have been long periods when stocks underperformed risk-free rates of return, and when stocks even turned in negative returns. Stocks did not recover their pre-Great Crash of 1929 prices until 1953, almost a quarter of a century later. It took over 20 years after 1966 for the market to make gains. And there have been lesser periods of 10 or more years when stocks performed very poorly. Most investors don’t have a lot of cash to invest when young and do the majority of their investing during middle age, thus a lengthy underperforming market burns up time they don’t have. In actuality, the stock market has mostly been a poor performer, the long-term average return juiced by the large – and unsustainable – gains of intense bullish periods.

  1. It’s Not Just the Fundamentals, Folks.

Picking stocks that will last the long term (as opposed to Enron, for example), grow in value and appreciate in price is tough. Yet to get rich at this kind of investing, the stock really has to do all three things. The B&H investor is looking for great fundamentals – a company that will grow its business and profits over the years. You could, alternatively, pick a great company that is out of favor and undervalued on the assumption the stock has to go up, but it could be years before the stock moves… if ever.

There are many vagaries that affect long-term success, such as changes in technology and markets, some unknown and unforeseeable even by the people in an industry being affected. Just buying stocks early in a bull market is no guarantee of appreciation, either. Who was the major search engine company before Google came along? Right; I can’t remember it, either. Can you pick the companies today that will be winners and growing for the next 20 years? OK, 10? Who would have thought GE would trade below $10 and morph from the best-run company in the world (or so many believed) into the Rodney Dangerfield of companies. And consider the next two points…

  1. Buy and Hold Does Not Produce Income.

Stocks just lying around the portfolio produce no cash flow except for dividends; assuming the stock pays dividends. Otherwise they just gather dust. Growth stocks, the ones most likely to be your home run, usually don’t. Everyone knows about naked options, but have you ever thought about non-productive stocks as naked stocks? If you could ask Warren Buffett, Donald Trump, Rupert Murdoch or Richard Branson their opinion of tying up precious cash in a non-producing investment for years (and whose value might also fall for years in a bear market), what might they say? You know the answer: they would tell you it’s all about cash flow.

If your investments aren’t producing cash flow, you’re being fleeced, once you consider the cost of carry. Because you could be investing your money in Treasuries at the risk-free interest rate (about 1.00% as I write), there is a very real cost of carry in holding unproductive stocks. When income is not being produced, you literally are hoping – gambling – that the stocks increase enough over time to produce wealth; or at least yield a return equal to the risk-free rate. Let’s hope you picked the right ones and that no lengthy bear markets intervene!

  1. Buy-and-Hold Ties Up Capital.

If you need money to send kids to college, or whatever, the B&H strategy’s lack of cash flow means that you have to sell stock in order to pull cash out of your assets. If the stocks’ prices are higher at the point that you need cash, wonderful; simply sell some shares and use the taxable gain as you wish.

But what if the stocks are flat, or down? In that case you are digging into your capital, perhaps taking a loss, in order to get your hands on some cash. This, obviously, is not a good practice. And it is all because the stocks are not producing income. You might as well have stashed the cash in a safe-deposit box in that case. Remedying that income problem, while investing conservatively, is precisely the point of this article

             5. Value Investing: Whose Value?

Wall Street touts B&H as value investing, but picking the companies with the greatest “value” is no sure road to riches. First of all, stock price doesn’t necessarily bear any relation to value, now or in the future. Second, no two people, even experts, can very often agree which companies represent the greatest “value” – even in the same industry! If you select an investment based on its inherent value, whose value are you using? Perhaps the analysts who touted stocks all the while knowing they were garbage? How about brokers, financial planners or others expecting a fat sales commission? Hint: it had better be your value, and thoughtfully arrived at; and you’d better be right.

Unfortunately, perceptions of value rule, not value itself. Studies don’t show much of a correlation between value and return, and the best returns often come from hot-shot stocks that are not very conservative. They can generate huge returns, but many will flop. Can you pick the “good” ones?

  1. An Odd Thing: Wall Street Doesn’t Do It.

Wall Street preaches the B&H strategy, but Wall Street doesn’t buy stocks and hold them! Wall Street firms are traders. And the large Wall Street firms seem to do quite well trading, much better than peddling undecipherable derivatives with 40:1 leverage, which has destroyed Bear Stearns (a firm that no longer makes money the old-fashioned way), Lehman Brothers and Merrill Lynch. Odd that Wall Street would tout a strategy they themselves don’t employ. Ah, there’s no mystery: Wall Street firms need buyers for stocks, so touting the B&H strategy makes dollars-and-sense for them. After watching them cause the 2008-2009 meltdown, and now having to pay for it, why on earth would you waste your time listening to what the white-shoe guys in Wall Street say? They turn their money, generating cash flow all the time. Shouldn’t you?

  1. Is your timing right?

The two elements of success in buy-and-hold are: i) you must pick stocks that actually appreciate in value, and (ii) much of your investing ideally will occur during periods when the stock market and a good economy causes real growth in asset values (your stocks). If you don’t have enough cash to begin investing until your early 30’s and have a lackluster market for 20 years thereafter, you may be into your 50’s before seeing a real increase in asset value. A third element, dividend returns, also deserves mention, but to some extent buy-and-hold investing requires a choice between high dividend yield and growth.

We have seen two market crashes – one beginning in 2000 and another in 2007 – in a span of less than 10 years. One sore investor’s – Max – comment to me says it all: “I’ve been ruined twice in less than a decade.” Well, actually not; he didn’t sell at the market bottoms and thus never took a deductible loss. His problem is that he didn’t realize a return because he didn’t liquid the gain in value through the late 1990s or in 2007. He wants to know: where’s the beef? Had he sold at or close to market tops and bought the bottoms, he would have made a killing.

In my opinion, the smartest buy-and hold strategy is to buy stocks close to the bottom of a bear market; a greater than 50% loss off the market high is a reasonable place to start looking for bargains. The first half of 2009 has presented just such an opportunity. Buy great companies that pay a good dividend (a bargain-basement stock price greatly increases dividend yield) and are likely to participate zestfully in the expected market rebound. Yields of 5% or more are available as I write this, on marvelous companies that grow earnings consistently.

Inevitably, a market top will be reached. Why on earth would one passively hold those stocks through another bear market cycle as values plummet? One reason might be dividends, but not many investors are getting 5% or more annually. Another approach, explained further on, is writing calls on your portfolio stocks. In fact, a declining market also offers an opportunity to write calls on long-term holdings. The stocks are declining anyway, so why not pull a nice income out of them? Stocks should never be allowed to laze around your portfolio.

Please understand: I am not debunking or deriding long-term investing. But – done properly – it isn’t simple, it isn’t easy and it doesn’t always work so well, due to the luck element. And you must be ruthless about discarding lackluster performers, perhaps re-balancing in tune with market or economic trends. If this sounds a bit speculative, it is.

Studies have shown that as much as 40% of Americans’ retirements will come from investing. Invest wisely, my friend!

Instead of “wishing and hoping” that the stocks in which you tie up precious cash, unproductively, will ride to your retirement rescue and produce wealth… more investors should instead try Income Investing – a conservative strategy that can produce as much as an average monthly return of 3% to 5%, which builds wealth pretty quickly.

This series is unabashedly about covered call writing as a means to generate an income every single month from stock ownership. Done right it works pretty well in most markets. It can also be done in a manner to limit risk to just a few percent of the amount invested.

Imagine that: you can force a stock to generate an excellent income – pay you a handsome rent – while defining and limiting your maximum risk at the outset. And you can choose how much risk to undertake!

If you already know about covered calls and can deploy the strategy with consistent success, then these methods are just what you have been seeking; they will only take your writing to a higher level. If you have not found covered call success, or haven’t tried them yet, or are not quite sure what they are, you’re in for a treat.

But first, a question urgently needs to be answered. Why aren’t people shouting the good news about covered calls from the rooftops?

>> What do billionaires understand about compounding?