Buy-and-Hold Is Dead

NEW YORK (Real Money) -- One of the many things I do to express my inner geek is read academic studies on markets and finance. Many market innovations and tools have come out of the ivory towers over the years and it is foolhardy to dismiss them out of hand.

A lot of it is nonsense like the efficient market theory and other elegant theories that work well in the classroom and not nearly as well out in a real world full of messy emotions and personal bias. Others, like the work of Lakonishok, Piotroski, Altman and others, are applicable and can help us gain a tremendous advantage in our investing activities.

One of my favorite academics to follow is Dr. Andrew Lo. His adaptive market hypothesis is one of the best papers on stock markets and investor success I have ever read. He tells us that markets adapt and the forces of evolution and natural selection apply to market returns just as they do to the rest of the world. Investment styles come and go so investors must adapt to succeed according to Lo. At the end of the day, the ultimate job of a long-term investor is to survive. That makes a lot of sense to me. One of the reason I favor the deep value and distressed approach to markets is that it reduces the risk of permanent loss of capital and helps ensure survival.

Recently, as I was sitting around the house practicing the art of nothing while watching market forces give a lift to my grab-bag of cheap stocks, a friend sent me a recent interview with Lo. In a discussion with Charles Wallace of "Money Magazine," Lo said that buy-and-hold was dead as an investment approach. He blamed the demise of the long-held market shibboleth as the result of the increase in volatility in the financial markets. Holding an index or mutual fund for decades will not work for today's investor as spikes in volatility and risk can quickly wipe out any gains. We have seen this twice since the turn of this very young century.

He blamed the risk on the large pools of money, such as hedge funds, swinging from style to style and asset class to asset class looking for returns and the increased leverage of derivatives used by the funds. He compared it to clearing brush with a chainsaw. You can clear a lot of brush, but it's also a great way to lop off a few body parts in the process.

But it occurs to me that it is the wild chainsaw clearing activities of the large funds and traders that can create profitable opportunities for the rest of us. You may be able to clear the big stuff with a chainsaw, but for the nooks and corners of the yard you still need pruning shears. As the large pools of capital flock from asset to asset, they miss the small stuff. Their size prohibits them from considering small and microcap stocks, for example. This is one of the reason I have been an advocate of avoiding stocks that are in the major indexes and ETFs. You avoid the price distortion of chainsaw trading and volatility spikes and can focus on business valuation.

As the large traders move around the investing yard in search of returns they leave a lot of debris behind. Often in the debris we find quality fruit that was indiscriminately whacked off the vine. In recent years, banks were savaged by the market leaving behind many smaller banks with solid balance sheets trading at a fraction of their underlying value. It looks to me like the chainsaws are currently whacking away at natural gas and coal and a lot of good stuff is falling to the ground.

When they do inevitably whack off a finger or toe in their sometimes desperate search for alpha, those of us without an addiction to leverage and size can profit. When fear hits the stock market and volatility spikes, selling cash-secured puts becomes very profitable. The massive selling of forced liquidation in an over-owned asset class and create extreme undervaluations that can be profitably exploited.

Buy and hold is dead. Most of us have been incredibly spoiled by two decades of above-average returns in the stock market and just buying the market and holding it worked out pretty well. Buying what is safe and cheap and selling it when it is fully valued has always worked and I think it always will. If we focus on this simple truth, we can profit from the excessive risk taking of others and earn outsized returns with far less risk.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.

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