DOES THE BUY AND HOLD STRATEGY REALLY WORK AMID CURRENT HIGH VOLATILITY IN EQUITY?

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Melvyn Stokes
8 years ago
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1 DOES THE BUY AND HOLD STRATEGY REALLY WORK AMID CURRENT HIGH VOLATILITY IN EQUITY? Executive Summary: We start this analytical report on relevance of Buy and Hold Strategy in recent times by analyzing the returns generated by Bombay Stock Exchange over different periods of time. Taking this analysis as reference point, we discuss why the criticism against buy and hold strategy is not validated. We then discuss what makes this approach fallible and what an investor should do to avoid such fallacies to generate satisfactory returns on equities over a long period of time 1

Bombay Stock Exchange over different periods of time.

2 Table of Contents: Topics Page number BSE Returns 4 Criticism 5 Counter Arguments 6 What can lead to failure of B&H approach 6 What an investor must do to avoid these pitfalls 7 Conclusions 8 Bibliography & Webliography 9 2

failure of B&H approach 6 What an investor must do to

3 No Year ending March BSE Sensex on 31/03/XX Rolling 1yr returns % Rolling 5yr returns % Rolling 10yr returns % Rolling 15yr returns % Probability of loss Returns beyond 1 year are on compounded annualized basis Observations: One year returns are quite volatile. We see several years giving negative one year returns (in red) immediately after generative impressive 1yr return in erstwhile year Long term returns are less volatile; risk in equities reduces as holding period increases 3

1994 3779 66 40 31 27 16 1995 3261-14 33 25 24 17 1996 3367 3 24 19 22 18 1997 3361 0-5 21 20 19 1998 3893 16 11 26 21 20 1999 3740-4 0 18 20 21 2000 5001 34 9 20 19 22 2001 3604-28 1 12 13 23 2002

4 As holding period increases, the probability of loss reduces. As we see, it is almost 0 for 10 year holding period and absolutely 0 for 15 year holding period The great compounding effect: Rs 1000 invested in Sensex in 1979 becomes Rs 1,60,000 over 32 years at CAGR of 17.18% The 15 year returns seem to replicate GDP growth of the economy in nominal terms leading us to infer that stock market returns reflect the economic growth of the nation but in long term The returns produced by Indian Equity markets clearly support the buy and hold investment approach. Moreover, the volatility which many critics of this approach consider as their friend may well turn out to be their biggest foe as evident from 1 year returns of years like 1993 & In those years, any investor trying to time the market would have had a bad time. With this analysis as our reference point, we will look into what are the arguments against this strategy Volatility is too significant The critics of buy and hold approach opine that stock markets off late are very volatile. As a result, it is too difficult to resist the temptation of being active buying and selling. For example, price of a stock is Rs100 today. If tomorrow it becomes Rs130, it is too difficult to resist selling it off. In fact it may become Rs 70 next week so it is best to sell off and book the profits Markets might not go any further up even after 10 years or 15 years Critics opine that in last few years, owing to poor global economic scenario, the stock markets have not moved considerably upwards. As a result, buy and hold does not work and it is best to buy low and sell high benefitting from the volatile markets Counter arguments to the above mentioned view points against Buy and Hold theory Investment operation is the one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting this requirement are speculative 1 Keeping this definition coined by legendary Ben Graham in perspective, the investors trying to time the market can be termed as speculators. Their operation is like gambling on the outcome of a game in a casino. It can work for you if you are lucky and against you if you are not. Thus the entire operation of trying to time the market in order to buy low and sell high is speculative. How can we come to know what the stock price will be tomorrow or next week or next month? Nobody can. Because in short run, markets are like voting machine as Mr. Buffett often puts it. And it s impossible to find out the inclination of the crowd. Thus trying timing the market is a merely trying to test one s own luck and therefore one is as likely to fail as succeed. 4

It should also be noted that in the long run, markets are like weighing machine. They represent the true worth of the business and the economy in general. The table shown validates this point.

5 It should also be noted that in the long run, markets are like weighing machine. They represent the true worth of the business and the economy in general. The table shown validates this point. Therefore one can be rest assured that in long term markets will go up, if the businesses in the market perform well. Thus, by buying and holding the investor is basically investing in the growth of the economy or the individual businesses in that economy. Buy and Hold Strategy is not infallible 1. This approach fails when the economy fails to grow or the business in which one has invested fails to perform. For example, Greece Stock Market collapsed from 2400 points to 800 points over 10 year period from This is because the economy of Greece failed. Himachal Futuristic Communications has given -82% return over a period of 10 years from 2002 to When the investor enters the market at high valuations, his returns get affected. Thus, somebody entering BSE in March 1992 when markets had touched new highs would have made abysmal -2% (compounded annualized) over 10 year period. On the other hand, somebody entering BSE in 1990 when many felt India will be bankrupt sooner or later would have made 20% returns annually compounded. Thus, an investor should be averse to entering the market when the stocks are overvalued due to euphoria. As Mr Buffett puts it, Be fearful when others are greedy and be greedy when others are fearful Thus Buy and Hold Approach is not infallible but the fallacies can be reduced if one needs to- 1. Invest in strong and emerging markets like India India has 1.2bn population which is very young and large number of them will move to the working age in next 10 years Source: Euro Monitor International from national statistics, UN / MOSL 5

Thus, by buying and holding the investor is basically investing in the growth of the economy or the individual businesses in that economy. Buy and Hold Strategy is not infallible 1.

6 India s dependency ratio should continue to fall and savings rate should continue to rise, facilitating higher investments Source: CLSA Research Dependency ratio is defined as proportion of population above 60 years divided by working population (aged between years) Key Parameters FY2011 FY2020E GDP (US $bn) Exports (US $bn) Mobile Connections in mn Wheeler Unit sales in mn Car Unit Sales in mn India expected to emerge 5 th largest economy by 2020 Increasing affordability, low penetration of consumer goods, increasing credit, favourable demographics and increasing export competitiveness point to sustained growth ahead Source: BofA Merill Lynch 6

Mobile Connections in mn 811 2031 2 Wheeler Unit sales in mn 11.8 24.8 Car Unit Sales in mn 2.5 7.

7 2. Invest in good businesses Good Businesses are those that enjoy wide economic moats. They have either strong franchises, innovative products, strong barriers to entry or cost advantage which is difficult for competitors to emulate. Such businesses keep generating cash with very little cash consumption Example: Warren Buffett bought Coca Cola in 1988 precisely because it had such great entry barriers and economies of scale that its Free Cash Flows to the Equity had CAGR of 18% in phase. 3. Buy Business, not stock When a private businessman owns a business he looks to grow it over a period of time and generate cash flows year after year. The investor should have a similar view towards the business. Instead of buying a stock to sell it off next day, one should buy good businesses that generate cash flows at high rates of return and hold them as long as the businesses have favourable long term prospects. This is a trait that differentiates investor from a speculator. 4. Buy businesses when market has undervalued them When market holds more optimistic view of the long term prospects of the business than they ought to be, the business is selling at exorbitant rates. By buying business at exorbitant price, he risks his return on investment. Thus he should look to buy the business when the market has become fearful of the business. This generally happens when there is a drop in quarterly earnings or some regulatory problem in the industry in which the business operates. These events generally do not affect long term prospects of the business but market hammers such stocks by over reacting to the bad news. That is the best time for an investor to enter the business and hold it till the time the business enjoys the economic moats Conclusion: We saw that in Indian context, buy and hold strategy has worked very well in last 32 years and there is a high probability it will work well in the coming years. Although the buy and hold approach is not infallible, it is perhaps the best available approach to rational investing. The fallacies of this approach can be eliminated by careful analysis and disciple in approach. The alternate methods like trying timing the market are highly speculative, lack rationality and logic as we saw in this report and therefore cannot be advocated. Thus, for an investor, the buy and hold approach is the best approach to make money in the equity market in the long run. 7

Such businesses keep generating cash with very little cash consumption Example: Warren Buffett bought Coca Cola in 1988 precisely because it had such great entry barriers and economies of scale that

8 Bibliography: 1. Graham B., Dodd D.: Security Analysis, Graham B.: The Intelligent Investor, Hagstrom R.: The Warren Buffett Way, 1995 Webliography:

com/globe-investor/investment-ideas/numbercruncher/why-buy-and-hold-doesnt-always-work/article535795/ 2. http://www.forbes.

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