Personal Perspective: 'Buy and Sell' Investing

By Kenneth R. Solow



Google the phrase "buy and hold is dead" and you'll come up with more than 11 million hits. It would seem that means that investors have suddenly developed a powerful new interest in discussing buy and hold investing.

"Buy and hold" is a term typically reserved for a style of investing that presumes that the excess returns earned by an asset class in the past will repeat in the future, so therefore the best investment strategy is to buy the asset class and hold it until the excess returns are actually earned by the investor.



Patient Investing

In the investment world there is a fancy name for excess returns called "risk premiums," but the theory is the same. The key here is that it doesn't matter how much you pay for the asset; the historical risk premiums should still appear.

As an example, buy and hold investors believe that they will earn the average historical excess returns of stocks over cash, which is about 8-10% depending on what day you are measuring from, if you will only wait long enough to earn the returns. Therefore the most important investment attribute for buy and hold investors is patience. If you will only wait long enough, the excess returns are supposedly yours for the taking. Ironically, buy and hold investors see no risk in this proposition at all.



Efficient Markets Hypothesis

Unfortunately, in order to make such a claim about the inevitability of earning excess returns in the future, investors must rely on several important and misunderstood notions about the economy and the forces that govern changes in prices. These assumptions are fundamental to a theory governing financial markets called The Efficient Markets Hypothesis.

The Efficient Markets Hypothesis says that financial markets are so efficient that prices already reflect all of the news available to investors. In addition, when there is "news," market prices instantly adjust to the new "correct" price (economists call this the equilibrium price). Therefore, there is no way to earn excess returns above what the market offers, and the best thing to do is own the market itself.

The two most important elements of the efficient markets hypothesis are: 1) The economy is stationary, meaning that the forces that govern price changes never change; and 2) Investors have perfect economic foresight, meaning that they can perfectly forecast the correct future prices.

Now, it may not seem obvious to all, but it is becoming apparent to many (see 11 million-plus Google hits) that there is something terribly wrong with this theory. If we are to believe the economy is stationary, then we would have to believe that the fall of the Berlin Wall, global warming, the aging of the Baby Boomers, the diminishing supply of oil and the creation of the Internet all have had no impact on the economy.

If we are to believe that investors have perfect economic foresight, then we must believe we have not experienced the bursting of the technology bubble, the real estate bubble and now the credit bubble over the past decade. It seems that unbiased investors would all agree that markets are not efficient if we are to believe our eyes, as well as our brokerage account values, and therefore the underlying theory underpinning buy and hold investing is at best troubling, and most probably, wrong.



Buy, Then Sell

If we shouldn't buy and hold because the underlying theory is silly (yes, silly), then perhaps we should do it because there is no better alternative. The alternative to buy and hold investing is obviously "buy and sell" investing, which critics call market timing, but which is really any strategy other than buying and holding.

In this new strategy of buying and selling, investors rely on a different proposition when owning risk assets. They try to buy assets when they have value and sell them when they don't have value (however you define value).

It is often surprising to people when they learn that the fundamental investment theory taught to all professional money managers denies that such a situation can occur. Remember, in efficient markets there is no opportunity to earn excess returns and prices instantly correct to the one perfect price. There is no such thing as finding good value in the investment markets, and perhaps even more surprising, no reason to even attempt to earn excess returns.

The case for active management rests on the notion that informed investors can recognize value opportunities in markets and exploit them in order to earn excess returns. Value investors believe that relying on historical average risk premiums to appear in the future is a high risk strategy when markets are expensive.

Let's all begin studying the new "buy and sell" investment strategy that does not rely on the belief that past risk premiums will appear in the future regardless of market or security valuations. Besides, if you look it up, you are likely to get a lot fewer Google hits.



Kenneth R. Solow, CFP, is chief investment officer for the Pinnacle Advisory Group Inc. and is the author of the recently published book Buy and Hold is Dead (Again). He can be reached at 410-995-6630 or 301-621-8007.