by Peter McKenna

Before becoming an event trader, I firmly believed that the buy-and-hold strategy was the best way to make money in stocks.  As a reporter, I wrote countless stories that warned investors about the dangers of short-term investing.  The concept behind buy and hold was simple: In the short term, the market fluctuates wildly.  But over the long haul, it will make tremendous gains.  This means that investors must ignore the short-term volatility and hold stocks for the long term, letting the market go through its up and downs without concern.

The wisdom of this discipline seemed beyond dispute.  I looked at charts of the DOW and S&P 500.  Both of them moved up and down over the short-term, but over the long term they moved relentlessly upward.  The day that I convinced myself to forgo the need for immediate gratification, to patiently wait for my long-term reward, I felt that I achieved a high level of maturity.  Besides, the most respected money managers in the world preached buy and hold as if it were a religion.  Who was I to disagree?

I asked my broker to recommend five stocks that would be good long-term investments.  He recommended a half-dozen tech stocks, which at the time were raging upward on a daily basis.  He said these stocks were in the first stages of a long, remarkable period of growth.  It was imperative, he said, to get into these stocks at the beginning.

I bought three of the stocks recommended by my broker and vowed to hold them forever.  My fantasy was that the stocks would split several times as the price skyrocketed, giving me thousands upon thousands of shares of the best stocks in the world.

Several months later all three of my stocks had reached astronomical highs and then dropped off a cliff, falling more than 50% from their purchase price.  I sold them, incurring substantial losses.  Then, in an act of sheer stupidity, I used my remaining money, and new money to boot, to buy long-term call options on the same tech stocks that had just put me deep into the red.  The experts said tech stocks were just taking a breather and that a new wave of the bull market would soon begin.  This too, sounded like common sense.  I believed the experts, reasoning that the incredible leverage of call options would eventually allow me to recover every cent of my losses, and possibly make money as well. 

But there was no new bull market.  I bought the options, which rapidly lost value, just as corporate spending on Internet technology slowed and the tech bubble burst with a loud bang.

Bruised and battered, I went through a period of anger and self-pity.  I desperately wanted to recover my losses and put my dreams back on track.  I no longer trusted Wall Street professionals and the death of the bull market had sent us reeling into a bear market.  Stocks were crawling along the bottom, with no relief in sight. 

I began to examine my decision to buy and hold tech stocks.  I made a list of the reasons then I made a list of the flaws.  Here’s what I found.

Why Buy and Hold?

I bought tech stocks for the long term because I had accepted the theory that letting money grow over time is superior to all other strategies.  I had been impressed when I looked at the charts of the DOW and saw the long, upward slope of the performance line.  I thought it was far better to let my money grow over time than risk losing it in a flurry of frequent trades.

The Flaws

The buy-and-hold theory has two major flaws.  First, while it is true that the market has gone up over the long run of the last 100 years, it has also stagnated for long periods, sometimes decades or more.  What happens if you need your money just as the market hits a rough patch?  Today, there are millions of investors who want to retire.  They started investing years ago, believing the value of their portfolios would grow and grow, because the market goes up over the long run. 

But just the opposite has occurred.  Countless investors today have little or nothing just when they need it the most.  The success of the buy-and-hold theory depends on when you invest and when you need the money.  It’s like spinning a roulette wheel.

The second flaw involves the number of stocks you buy.  When financial experts say the DOW and S&P 500 have made huge gains over the long term, they mean ALL the stocks in these indexes combined.  This means an individual investor who wants to capture the same long-term upward performance would literally have to buy ALL the stocks in the index and hold them for several years.  This would be an expensive way to invest.  Let’s say you could buy one share of each of the 30 DOW stocks for about $1,500.  But you would have to buy them one at a time, incurring 30 transaction fees.  Buying all 500 of the stocks in the S&P 500 would cost more than the average investor can afford, and you would pay 500 commissions.  True, you could buy index mutual funds or exchange traded funds that are based on indexes, but this means you are a mutual fund investor, not a stock investor.

Thus, there is literally no way for a stock investor to precisely capture the returns of the DOW or the S&P 500.  Long-term investors must put their money into a few DOW stocks or a few of the S&P 500 stocks.  Their success, even over the long term, depends on their ability to pick good stocks.  If investors buy good stocks, they can make money over the long term.  If they pick bad stocks, they will lose money, no matter how long they hold them.

Slowly, I began to realize that I should think for myself, rather than blindly accepting Wall Street’s theory of long-term investing, which is essentially a marketing strategy more than it is common sense.  The only way to capture the same long term market performance Wall Street loves to brag about is to buy all the stocks in an index, a strategy only the very rich can afford.

So, like many of you, I discovered the hard way that buy-and-hold can be a trap.  I decided that it works only if you buy the stocks of solid, well-run companies that sell products or services that are capable of generating strong earnings growth year after year.  And it works only if the market happens to be at a high point when your long years of waiting finally come to an end.  You have to be lucky enough to buy good stocks, and the calendar has to be on your side as well.