It's taken some knocks, but buy and hold is still sound, and essential, within a broader strategic allocation plan.
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By Jason Stipp | 09-12-10 | 06:00 AM | Email Article

The buy and hold debate, which we've stoked on Morningstar.com over the last couple of weeks, has suffered from a curious stumbling block: namely, what is the definition of "buy and hold"? It's difficult to debate whether something works or not--whether it's alive and well, or dead and buried--if you can't agree on what it is, exactly.

Jason Stipp is Site Editor for Morningstar.com

So just to muddy the waters a bit more, I'm going to throw my own recipe into the mix. However, given the lessons we've learned about this debate so far, I'm going to start with my definition of buy and hold.

And just so I don't hold you in suspense, the answer is no, it's not dead.

However, I also don't think it's a be-all and end-all. By itself, it has its weaknesses, but there are ways to overcome them and tilt the odds in your favor. And for that reason, buy-and-hold shouldn't be your only slogan, but it can be the one with the biggest typeface. It just needs some supporting context to make it work.

What My Dictionary Says About Buy and Hold
To believe in buy and hold is simply to believe that certain riskier assets, such as stocks, require longer holding periods in order for you to consistently realize higher returns versus other investments.

This is not to say that you won't get lucky and buy a stock that shoots up 20% or more in a week's time. But what has the potential to shoot up so fast also has the capacity to crater just as quickly.

So, to make sure that your upside potential overcomes the downside risk, history proves that these assets need some breathing room. Have the patience to fall one or two steps back before going three or four steps forward. Ibbotson data shows that a diversified basket of stocks (in this case, the S&P 500) has provided a total return of 9.7% on average every year from 1926 through August 2010, versus 5.6% for long-term government bonds.

Did you see those words "on average" in the last sentence? They probably should be in italics, because they're pretty important. Behind the scenes of those average annual returns are some good years, even some great years, but also some years that stunk up the joint. Just because they've outperformed over time doesn't mean that stocks haven't suffered bouts of poor performance--sometime even years of it.

But that's the whole point, right? You have to accept the risk of stumbles, and the actual stumbles (and yes, even the falls, too), in order to reap the rallies. Is it worth it? History says yes. Over time, the stock market climbs more stairs than it falls down.

And that's where the "hold" part comes in--and why it's so important. You've got to be willing to hold your stocks over the long term in order to maximize your odds of climbing more than falling, of beating those other asset classes.

This requirement for a longer time horizon is why I think it's so funny when I hear someone say, "Buy and hold didn't work in 2008."

To me, that's like checking a pot roast half-way through the cooking time and declaring the recipe didn't work.

So, What About the Lost Decade?
Ah yes. The lost decade for stocks. Well remember earlier when I said buy and hold wasn't perfect by itself? Let's talk about why.

To be sure, stocks can suffer severe and protracted periods of underperformance. They can get stuck in the mud and go nowhere. The last 10 years is a good case in point. If you had invested all your money at the beginning of 2000, this article is probably not helping your heartburn.

This is an important point: On its own, buy and hold has its weaknesses, and one of them is entry and exit risk (or more commonly, the risk of buying high and selling low).

The ultimate benefit accrued by buying and holding stocks can be severely weakened if you buy them at a premium. And certainly, because riskier assets have a higher potential for volatility, there is a very real risk that you will buy stocks at the wrong time (i.e., when they are overvalued).

And if you do buy at a steep premium, holding the asset over a long period of time won't necessarily help you recoup your losses, let alone start realizing a profit. Think about that rare Beanie Baby you ponied up for at the height of the Beanie Baby craze. Twelve years later, it's still in the back of your guest room closet--and it's still worth about 1/100 what you paid for it. (So just give it to your dog already!)

But as an investor, you don't have to play this high-stakes timing game. You can even out your odds of paying a fair price for stocks by dollar cost averaging--that is, investing small amounts of money into the stock market over time. If you invest a small amount of money consistently every month, you'll likely overpay at times when the market is running hot (like the tech bubble). But you'll also pay a fair price at other times, and sometimes you'll underpay for your investments (or get more for your money) when the market is depressed, such as in 2008. Over time, these overpayments and underpayments should net out to a fair average.

Dollar cost averaging removes the risk of going "all-in" at exactly the wrong time. Of course, you also give up the possibility of going "all-in" at just the right time, but very, very few people (and I'm talking about the pros here, too) can do that consistently. Plus, most of us have a long accumulation phase; we don't have a huge chunk of money to invest at any one time anyway. Our potential investment dollars are coming in small doses with each paycheck, making them natural candidates for DCA.

And by the way, the same dollar-cost averaging logic can work on the sell side, too. When you're ready to exit an investment, if you slowly draw it down, you avoid the risk of selling everything at exactly the wrong time--namely at the bottom of a recession.

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Jason Stipp does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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