Trading strategies attempt to time the market ex-ante by generating entry and exit signals. Buy and hold is post-hoc market timing. There is no way to avoid market timing, whether active or passive. The claim that buy and holders do not time the market is made in “attacking a strawman” involving market timing.
Passive funds have enjoyed large inflows of capital recently because they succeeded to convince investors that buy and hold is safe and market timing delivers lower alpha.
However, I am not aware of any report from these passive funds that shows how many buy and holders liquidated near the bottom of the last two bear markets. I suspect that many did but they came back to these funds after they were convinced that the Fed guarantees stock investments. Therefore, for those investors buy and hold is essentially a strategy, indistinguishable from a market timing method.
People look at past returns and recoveries after bear markets and post hoc assume that had they stayed in the market they would have realized the high annualized returns promised by passive investment funds. But is the future going to be similar to the past? Is it possible to have a prolonged slow recovery that will leave most buy and holders in the red for a long time, maybe for more than 10 years?
The last recovery from the bear market of 2008 lasted five years, or four years on a total return basis. Before that, it took about seven years, or six on a total return basis. If a recovery takes more than 10 years, many investors could be forced to sell. Then, whether buy and hold is passive or active investing actually depends on future length of recoveries from bear markets and not on past performance.
Below is a chart of S&P 500 that shows that buy and hold sometimes works and sometimes it does not. It is important to notice that “worked” periods are always followed by “did not work” periods.
We define a “did not work” period as the time required to recover to a previous high.
The above chart shows that buy and hold is a passive market timing method and more importantly a post-hoc one. A buy and holder always looks at history and wishes to have sold at market peaks. A salesman at a passive fund promises recovery and no loss of capital due to bear markets if the investor does not sell. Both operate post-hoc, the worst thing one can do in the markets.
Obviously, the last period is a “Worked” for buy and hold. Anyone who bought the breakout above the 2007 top has made money. Actually the bull market started in 2013 and before that it was a struggling recover with two major corrections in 2011 and 2012. By induction, the next period will be a “did not work”, necessarily.
Market timing is hard and requires a robust model and plenty of discipline. The transition from strategic to tactical investing is difficult for most. But buy and hold is not free of risks and there is a trade-off between not having to exercise discipline and the risk of rare events that can force a passive investor to panic and liquidate. Those who claim that buy and hold is risk-free are post hoc market timers.
If you have any questions or comments, happy to connect on Twitter: @mikeharrisNY
Disclaimer: No part of this article constitutes a trade recommendation. The past performance of any trading system or methodology is not necessarily indicative of future results. Read the full disclaimer here.
About the author: Michael Harris is a trader and best selling author. He is also the developer of the first commercial software for identifying parameter-less patterns in price action 17 years ago. In the last seven years he has worked on the development of DLPAL, a software program that can be used to identify short-term anomalies in market data for use with fixed and machine learning models. Click here for more.