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If 'Buy And Hold' Doesn't Earn Enough For You, Read This Now

Wednesday, January 08, 2014 7:00 AM

A popular investment strategy is to buy quality stocks and plan to hold them forever. The buy-and-hold strategy became popular because it works well -- sometimes.

From 1982 to 2000, buying and holding delivered exceptional returns. At other times, the results are nothing short of disastrous. Bank stocks offer an example of the latter case.

In 2006, Bank of America (NYSE: BAC) was one of the world's largest banks, with a profitable mortgage originating division. It seemed like the perfect company for a buy-and-hold investor, with the ability to earn steady profits from mortgage servicing rights and other banking operations. BAC began trading down as home prices peaked despite assurances from many analysts and policymakers that the housing market did not present a risk to the overall economy.

BAC has gained 500% since March 2009. Despite that gain, the stock remains more than 65% below its 2006 high, and long-term buy-and-hold investors are still showing losses. Anyone who bought the stock before May 2010 still has a loss on their position. Investors who bought in 2008 or earlier are also likely to be showing a loss.

Some buy-and-hold investors will point out that the dangers of individual stocks can be avoided with index funds. But the chart of the PowerShares QQQ (Nasdaq: QQQ) exchange-traded fund (ETF) demonstrates that indexes are not always a way to preserve wealth.

In addition to having all of the downside of a bear market, index funds place a limit on an investor's potential upside. They are guaranteed to achieve mediocre results since they're designed to track the market, not beat it.

We believe these types of results can be avoided by following a strategy we think of as "buy and hold until something important changes."
In the case of BAC, the real estate market and global credit crisis presented significant changes to its operating environment, and selling when these changes were evident would have avoided a large part of the losses.

Investors buying QQQ near its peak in 2000 were expecting to be rewarded because the Internet was about to change the world, as online commerce would replace all physical stores. By the time it became evident that would not happen, investors already had large losses. In this case, the technical picture changed in QQQ as the ETF fell below long-term moving averages in the middle of 2000 and gave numerous sell signals.

Rather than selling when something important changes, many investors stick with their original beliefs and view dips as buying opportunities. In hindsight, they often discover that fighting against the facts can become an expensive battle to wage.

In our work, we understand that every single position we open will eventually need to be closed. If we buy a stock, it might need to be sold when the relative strength (RS) changes or when fundamental measures like growth in cash flow slow significantly.

Planning to sell is consistent with the advice of value investors like Peter Lynch, the superstar manager of the Fidelity Magellan Fund for many years. Lynch advised understanding the reason you are buying a stock and keeping the rationale for the buy simple enough to fit on one side of a small index card. When the reasons you bought are no longer true, it is time to sell.

Action to Take --> Following this strategy will rarely help you get out at the top. But it should help you avoid the kind of losses that threatened the financial security of many individuals in bear markets that began in 2000 and 2008. We don't know when the next bear market will begin, but we do know that we will be looking for the change in economic, fundamental and technical conditions that accompany bear markets, and we will react to those changes rather than letting losses grow. Define what will cause you to sell each of your holdings and plan to act when those conditions are met.

This article was originally published at ProfitableTrading.com:
A Buy-and-Hold Twist for When a 500% Gain Isn't Enough

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Michael J. Carr does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.