Why Buy-and-Hold Investing Doesn’t Work

Andrew Lo is a bright economist at MIT who also is involved with several financial firms. A few years ago he coined the term adaptive markets to explain something we’ve been saying for years. Markets are composed of people, and people don’t react the same way to the same stimulus every time. They learn, or at least think they learn, and change. That means markets also change. Under these conditions, it’s tough for a buy-and-hold strategy to work. He recently did an interview with CNN Money that’s worth reading.

But doesn’t a simple buy-and-hold strategy address a lot of these issues of risk?

Buy-and-hold doesn’t work anymore. The volatility is too significant. Almost any asset can suddenly become much more risky. Buying into a mutual fund and holding it for 10 years is no longer going to deliver the same kind of expected return that we saw over the course of the last seven decades, simply because of the nature of financial markets and how complex it’s gotten.

Okay, but even during the so-called lost decade (2000 to 2010) someone who regularly put money into a 60% stock/40% bond portfolio would have had about a 4% return. Why isn’t that good enough?

Think about how that person earned 4%. He lost 30%, saw a big bounce-back, and so on, and the compound rate of return over the period was 4%. But most investors did not wait for the dust to settle. After the first 25% loss, they probably reduced their holdings, and only got part way back in after the market somewhat recovered.

It’s human behavior. Ask actual individual investors what their net rate of return was over the last three years, and see if it’s the same rate returned by the market. I bet you it’s not.