Lesson 31: Why “Buy and Hold” Is a Dangerous Strategy

Please don’t “buy and hold” your stocks.

It’s a common phrase taught to beginner investors, and as with most overly-simplistic advice, there are some useful pieces of truth to it.

However, in general, we think it’s misleading and would recommend a more engaged approach to investing.

Before we explain what’s wrong with “buy and hold” and what we’d recommend instead, let’s start by defining what investors mean when they say you should “buy and hold” your stocks.

According to Investopedia

Buy and hold is a passive investment strategy for which an investor buys stocks and holds them for a long period regardless of fluctuations in the market.

Now, this approach is actually rooted in some very good concepts. For example, it’s true…

  • You do NOT want to get swayed by short-term price movements in your stocks.
  • You do NOT want to jump in and out of stocks as you try to time the market.
  • You DO want to find high-quality companies you could hold for a long time.
  • You DO want to collect steady dividends over time.

So, when investors “buy and hold”, they do get some things right.

Then why do we think “buy and hold” is such a dangerous approach to investing?

Put simply, “buy and hold” encourages investors to try and guess how a company will perform over the next decade (an impossible task) and then ignore new information and hold no matter what.

It’s head-scratching why investors would make a stock purchase today based on all the information available and then basically ignore valuable new information about the company going forward.

Let’s look at a few examples to illustrate how dangerous “buy and hold” can really be.

Imagine you want to invest in a mid-cap regional bank that’s offering an incredible 10% dividend yield. The stock has historically been very steady, sales and earnings have increased like clockwork, and the company has offered a steadily growing dividend for 25 years straight.

It seems like a slam-dunk way to collect high dividend income from a steady stock.

So, today you buy a bunch of stock and eagerly wait for the dividend checks to roll in.

However, tomorrow morning you log in to see the stock has declined by a shocking 30%.

You quickly check the latest news and discover that the U.S. Department of Justice has accused the company of fraud for fabricating 10+ years of sales and earnings growth, the CEO and CFO have both resigned, and the board of directors has suspended the dividend indefinitely.

Just one day after buying this promising stock, your entire thesis has completely collapsed. It seems like their attractive growth, stability, and high dividend have all gone up in smoke.

It’s not your fault, how could you have known? It’s just plain old bad luck.

So, should you just bury your head in the sand and “buy and hold” the stock, assuming it will eventually recover?

To us, that seems crazy! There are literally thousands of other dividend stocks you could buy instead that aren’t currently engulfed in flames. Why would you decide to stick with probably one of the WORST dividend stocks on the entire market when you have so many other choices?

Sure, if you did a thoughtful, careful, in-depth analysis of the company’s legal and financial situation and confidently determined the stock and dividend would soon recover, then maybe you hold on.

But to blindly hold onto a stock that looks nothing like the company you bought yesterday seems like a mistake.

Now, of course that’s an extreme example. But it illustrates the point.

So, let’s look at a more reasonable example of why we think “buy and hold” is a poor strategy.

Imagine you want to invest in a company that provides farming equipment specifically for the marijuana industry. Your thesis is that legal marijuana will grow rapidly in the U.S. over the next decade and specialized farming equipment companies are the perfect way to profit.

(Note: This is a made-up scenario to illustrate our point. We’re not recommending any companies or industries for investment here.)

So, you do some research and find that there are two main companies that focus on providing equipment specialized to the marijuana industry: “Green Equipment Company” and “New Bud Mechanics.”

(Again, these are made up companies.)

After studying them both closely, you decide that Green Equipment Company is the better investment.

So, you buy a large position in Green Equipment Company and settle in for a nice, long, “buy and hold.”

However, over the next year, stock in Green Equipment Company declines -35% from where you bought it, whereas New Bud Mechanics climbs +45% over the same period.

What’s going on?

You do some research and discover that Green Equipment Company sales are in decline as marijuana farmers have found their products to be much less effective than New Bud Mechanics. Farmers complain the Green Equipment products are breaking down, destroying entire batches, and driving up their production costs.

On the other hand, New Bud Mechanics has recently launched a new line of products expected to increase farmer’s crop yields by +15% while reducing energy costs by -40%.

In the year since you bought the stock, nearly 30% of Green Equipment Company’s customers have terminated their equipment service contracts and moved over to New Bud Mechanics.

Finally, several high-ranking executives at Green Equipment Company have recently left to join New Bud Mechanics in their new product innovation and customer sales groups.

Based on the scenario above, which stock do you think is a better way to invest in the fast-growing legal marijuana trend?

The “buy and hold” investor would stubbornly double down on his investment in Green Equipment Company investment, saying, “Well, it’ll come back up eventually!”

However, we’d sell our Green Equipment Company stock, take the unfortunate loss, and invest instead in New Bud Mechanics.

It’s absolutely baffling to us why an investor would choose to ignore a range of highly-valuable new information about which is the best player in the industry.

Sure, when we first bought Green Equipment Company a year ago it was the industry leader. But in such a fast-growing and rapidly-evolving industry as marijuana farming, things are bound to change. And it’s clear that New Bud Mechanics currently has a big lead.

Rather than ignore the new information and stubbornly stick with the inferior stock, why not smartly move our bet to the clear winner in the space?

Again, this is just an imaginary example, but it’s one that plays out in investors’ portfolios every day.

Finally, here’s the simplest example we can think of:

You invest in a mediocre company because it’s deeply undervalued. Their shares increase by +50% in a week and you now believe the stock is extremely overvalued.

Why would you continue to hold a mediocre stock after your undervalued thesis has already played out?

A strict “buy and hold” mindset might see you passing up a quick gain and holding a mediocre company for the long-term.

We’d happily take the gain and look for another attractive investment opportunity. 

Now that we’ve walked through three illustrative scenarios, let’s look at a real example of the dangers of “buy and hold” investing.

The Decline of General Electric (GE)

In their book, Built to Last: Successful Habits of Visionary Companies, authors Jim Collins and Jerry Porras chose 18 “visionary” companies and compared them to 18 very similar, but much more ordinary, industry peers to try and see what the visionary companies did differently.

Released in 1994, their book went on to become one of the most classic business books of all time. In Chapter 1, they describe a visionary company like this:

What is a visionary company? Visionary companies are premier institutions—the crown jewels—in their industries, widely admired by their peers and having a long track record of making a significant impact on the world around them.

The key point is that a visionary company is an organization—an institution. All individual leaders, no matter how charismatic or visionary, eventually die; and all visionary products and services—all “great ideas”—eventually become obsolete. Indeed, entire markets can become obsolete and disappear.

Yet visionary companies prosper over long periods of time, through multiple product life cycles and multiple generations of active leaders.

One of their 18 most visionary companies was General Electric (GE). 

At the time, GE was considered one of the premier institutions in the world. It was the type of company many people called a classic “buy and hold” blue-chip stock. The company was founded in 1892 and had a long history of innovation and leadership.

In the 5 years after the book’s release in late 1994, the stock did quite well, strongly outperforming the market.

So how has GE performed since?

Let’s look at GE’s stock returns (red line) vs. the S&P 500 (blue line) from January 1, 2000 – February 10, 2019 (both including dividends):

Over the last nearly 20 years, the S&P has returned 166% (including dividends) while GE has lost -65% (including dividends).

That means GE has lagged the S&P 500 by a stunning -231%.

In June of 2018, GE was booted off the Dow Jones Industrial Average. 

And in October of 2018, the company cut its famous dividend down to just one penny per share. According to Barron’s, that ranks among one of the largest dividend cuts in the history of the S&P 500 (a -92% dividend cut).

Of all the biggest dividend cuts in the S&P 500’s history, General Electric owns three of the top 10 spots (2018, 2017, 2009).

That’s not the type of record you want to hold. 

Now, our point is not to pick on GE or analyze why the company has struggled. That’s a discussion for another time.

The point is that General Electric used to be an excellent, “visionary” company that most investors assumed was a “buy and hold forever” type of stock.

Somewhere along the way, that changed.

FORT WAYNE, IN – OCTOBER 4: An old building in the Electric Works compound once owned by General Electric and which will now be repurposed into multi-use campus in Fort Wayne, Indiana, on Oct. 4, 2017. (Photo by Damon Dahlen/HuffPost) *** Local Caption ***

(Above, an abandoned GE factory in Fort Wayne, Indiana)

Smart investors noticed the change. They were tuned in to the early dividend cuts, the excessive debt, the plummeting sales.

Over the past 20 years, many investors said, “Sadly, GE is no longer the company it used to be. I’m going to invest my money elsewhere.”

Hopefully those investors got out before last year’s brutal stock sell off.

But how many investors simply buried their head in the sand and said, “Nope! This is General Electric! GE is a great company. I’m not going be discouraged by the market selling off their stock. I’m going to hold tight and everyone else will catch on.”

What’s missing for that investor is an honest ongoing evaluation of whether GE is still the visionary company he invested in many years ago. If so, then great, continue to hold tight.

But if all the original reasons for buying GE in the first place (industry leadership, healthy dividend, healthy balance sheet) are gone – why is he still holding the stock?

So, if “buy and hold” is a bad strategy, then why do so many wise investors promote it?

In fact, Warren Buffett, the “Oracle of Omaha” is often associated with the “buy and hold” concept. How could one of the greatest investors of all time be wrong?

We’d suggest he isn’t wrong. He’s just misunderstood.

Wait! What About Warren Buffet?

Let’s look at a few famous Warren Buffett quotes about how long you should hold your stocks:

  • “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”
  • “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”
  • “Our favorite holding period is forever.”

So, it seems like Warren Buffett is saying you should hold your stocks forever, right?

We interpret these quotes differently than most investors.

Rather than hearing, “You should buy and hold your stocks forever.”

We hear, “You should buy companies that are so amazing that you WISH YOU COULD hold their stock forever.”

There’s a huge difference between those two interpretations.

The first one follows the classic “buy and hold” mantra, whereas the second one is more about finding great companies to buy.

We don’t think think Buffett is saying you SHOULD hold forever, we think he’s saying you should invest in a company that’s so good that you WANT to hold forever.

In fact, let’s look at the full context of Mr. Buffett’s quote (our emphasis added):

“In fact, WHEN we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.”

With the full quote we can see Warren Buffett is basically saying, “WHEN we own outstanding companies, we like to hold them forever.”

And sure, wouldn’t we all!

If you buy stock in an outstanding business with outstanding management that just keeps delivering incredible stock returns year after year, why wouldn’t you want to hold it forever?

On the other hand, we believe if Warren Buffett became convinced one of his holdings was no longer an outstanding business with outstanding management, he’d look to sell his position.

In our interpretation, Mr. Buffett isn’t proclaiming a “buy and hold forever” mandate, instead he’s talking about always trying to buy high-quality, growing businesses at a fair value – and we completely agree!

In fact, let’s look at a perfect example of where “buy and hold” worked incredibly well.

In contrast to General Electric’s collapse, let’s look at Apple’s climb.

The Incredible Rise of Apple (AAPL)

When it comes to a winning example of “buy and hold”, you need look no further than Apple stock.

In our example above, we watched General Electric struggle and ultimately plummet from January 1, 2000 – February 10, 2019.

Let’s look at how Apple stock (red line) performed vs. the S&P 500 (blue line) during the exact same time period (both including dividends).

Over the last nearly 20 years, the S&P has returned 166% (including dividends) while Apple has gained 4,747% (including dividends).

That means Apple has crushed the S&P 500 by a stunning 4,581%.

Apple is the perfect example of a winning version of “buy and hold.”

Any investor who held through tumultuous earnings results, the passing of founder and visionary Steve Jobs, and two recessions was handsomely rewarded.

The point is that it shouldn’t be blind luck whether you “buy and hold” GE (devastating losses) or Apple (incredible profits). Along that 20-year path there were many quarterly batches of fresh new information that often told you:

  • Uh-oh, something is wrong with GE.
  • Apple is doing great!

It’s not about picking an arbitrary holding period, it’s about regularly checking up on your investments along the way.

So, rather than “buy and hold”, we’d like to borrow a phrase from Mad Money’s Jim Cramer.

What to Do Instead: “Buy and Homework”

Rather than “buy and hold”, we like Jim Cramer’s phrase, “buy and homework.”

Investopedia describes it like this: 

Buy and homework is a phrase coined by TV personality Jim Cramer, host of the CNBC show “Mad Money.” It is based on the idea that buy and hold is a losing strategy.

In Cramer’s view, people who take a passive approach to investing are asking for trouble. Instead, he believes that investors must be prepared to make strategic decisions and react to changes in the market or unexpected fluctuations in stock performance.

Cramer’s buy-and-homework strategy means that investors should spend at least one hour a week researching each stock in their portfolio.

And quoting directly from Jim Cramer on The Street

But if you fall back on a buy-and-hold strategy for an EMC (EMC) or a Microsoft (MSFT), I can assure you that you will be soundly beaten by professional managers with good track records who are actively searching for good stocks all of the time.

We believe it’s critical to constantly be checking to make sure your investments are still living up to their original promise.

Why did you originally buy them? Fast growth? Strong leadership? High dividends?

Whatever the reason, it’s worth checking to make sure they still offer whatever initially made them attractive to you.

This is no different than anything else you buy to “do a job” for you. If you buy a car and it stops driving, you replace it. If your fridge stops cooling food, you replace it. If your investment advisor isn’t providing good advice, you fire him. 

Why should stocks be any different? If you bought a stock to do a specific job for you (e.g., provide dividend income, be undervalued, be a steady blue chip stock) and it becomes clear the stock is failing at its job, you should consider replacing it!

Let us be crystal clear here: There’s nothing wrong with buying and holding a stock. If you can find a company that delivers consistently strong performance for the next 20+ years, hold on tight!

It’s not about holding for a specific time period.

We could give an example where holding a stock for two days was far too long (such as holding the fraudulent mid-cap bank in our first example above).

And we could give an example where holding for 20 years was far too short.

The point is not to pick any hard holding period and blindly stick by it. Instead, constantly ask yourself, “Are these the best possible stocks I could own given my investment goals?”

We believe you should rebalance your portfolio often, relying on the latest information to make sure you’re always holding the best stocks for your goals.

Why try to pick a stock that will hopefully perform well 10 years into the future when you can see what’s performing well with 100% clarity today?

Of course, you want to buy companies that will outperform long into the future. But we’d recommend checking in regularly to make sure they’re still on the right path.

The biggest challenge investors face here is finding the time to regularly stay on top of the 10-30 stocks in their portfolio.

That’s why many smart investors rely on stock investment newsletters, financial advisors, investment clubs, or other methods of getting high-quality, up-to-date analysis on the best stocks without having to dedicate dozens of hours each week to research.

Lesson Summary: Why “Buy and Hold” Is a Dangerous Strategy

If we had to summarize this lesson into one simple sentence, it might be this:

You need a good reason to buy a stock and a good reason to sell a stock.

It’s that simple.

Jumping in and out of stocks without a good reason is a losing strategy. And blindly holding onto investments forever is also a losing strategy.

Instead, you should constantly be evaluating whether your portfolio still meets your original goals or whether there are better choices available.

Below are the major takeaways from today. In the next two lessons, we’ll cover exactly what are “good reasons” to buy and sell your stocks.

  • Buy and hold is a passive investment strategy for which an investor buys stocks and holds them for a long period regardless of fluctuations in the market.
  • We feel “buy and hold” encourages investors to try and guess how a company will perform over the next decade (an impossible task) and then ignore new information.
  • We don’t think think Warren Buffett is suggesting you SHOULD hold forever. We think he’s saying you should invest in a company that’s so good that you WANT to hold forever.
  • Rather than “buy and hold”, we like Jim Cramer’s phrase, “buy and homework.”
  • Cramer believes that investors must be prepared to make strategic decisions and react to changes in the market or unexpected fluctuations in stock performance.
  • Don’t pick any hard holding period and blindly stick by it. Instead, constantly ask yourself, “Are these the best possible stocks I could own given my investment goals?”
  • We believe you should rebalance your portfolio often, relying on the latest information to make sure you’re always holding the best stocks for your goals.
  • Jumping in and out of stocks without a good reason is a losing strategy. And blindly holding onto investments forever is also a losing strategy.
  • Smart investors rely on stock investment newsletters, financial advisors, investment clubs, or other methods of getting high-quality, up-to-date analysis on the best stocks without having to dedicate dozens of hours each week to research.
Author

Todd Lincoln

Author

Passionate stock market investor with deep experience trading small cap, dividend, and growth stocks.

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