Chapter 7
Why Does Buy-Hold Even Exist?
My secretary Gail made a mean meatloaf from a recipe that had been in her family for generations. She passed the recipe on to her daughter, who made the dish the traditional way, too. One evening, when Gail's daughter was preparing meatloaf for a family dinner, she carefully discarded the ends of the meatloaf as she'd been taught. As she did so, she said, “Mom, I know I should slice off the ends of the meatloaf, but why?”
Gail stared at her. “You know, I'm not sure. My mom just always served it that way. She'll be here in a few minutes. Let's ask her.” When her mother arrived, Gail and her daughter were anxious to solve the mystery of the meatloaf. “Why did I cut off the ends of the meatloaf?” said Gail's mom. “Easy. My serving tray was shorter than my baking pan. The meatloaf didn't fit unless I sliced off the ends.”
Generational Amnesia
Gail had fallen into that old trap: “We do it that way because that's how we've always done it.” The meatloaf mystery is a great example of generational amnesia—a big part of the buy-hold backstory.
Prior to the bear market of 2000, the market had gone up for nearly 20 years almost uninterrupted. Twenty years—that's basically an entire generation of investors. Figure 7.1 is what the market looked like during the time this lucky generation was investing, from 1981 through the end of 2000.
Figure 7.1 The 20-Year Bull Market (February 1981 to August 2000)
Look at the long gentle rise. It's a beautiful thing, isn't it? Why wouldn't you want to buy-hold? That long-running bull market never dipped too far down, and yes, it always came back. Add to that the fact that baby boomer investors were still working and contributing to their retirement plans and savings accounts, and they didn't need to live on their investments. Those three things combined validated buy-hold for 20 years.
During an entire generation's financial childhood, buy-hold worked. Boomers had no reason to question the strategy.
The Rest of the Story
But that beautiful 20-year bull market didn't last (see Figure 7.2). As Paul Harvey used to say, “And now, the rest of the story…”
Figure 7.2 The 20-Year Bull Market Aftermath (August 2000 to October 2002).
Not only did that bull market not last, we haven't seen a nice upward slope like the one shown in Figure 7.1 in some time. The volatility that we've experienced recently may be bumpier than normal, but it's actually more typical than that smooth period from 1981–2000. It was an anomalous period in the history of the market. But that's when many of today's investors were introduced to the market, and that's when buy-hold caught on.
The Rise of Mutual Funds
The mutual fund industry also grew during this glorious bull market, adding weight to the buy-hold myth. Don't get me wrong; I think mutual funds are a great invention that helped democratize investing. Before the advent of mutual funds, people who wanted to properly diversify and avail themselves of the latest research and access the best quality managers could do so only if they had millions of dollars to invest. The idea behind mutual funds was to pool all the investors' money so there would be enough dollars in that fund to hire the good managers and access the research and follow healthy investment strategies formerly available to only the very wealthy.
As you can see, mutual funds are terrific for the small investor. During that great bull market they really exploded, and are now the most popular form of investment for the average investor.
However, there's a built-in conflict: mutual fund companies make less money when people are out of the market. Because of this, mutual fund managers often encourage people to stay the course and stay in the market. The industry spends millions of dollars selling the idea that people should hold onto their investments no matter what, so that investors hear the buy-hold message over and over again from multiple media outlets.
And of course, buy-hold happened to work during that beautiful 20-year period of steady growth. The fact that it was working, and that the mutual fund industry kept promoting the idea made buy-hold the way to invest. And as with any idea, when it's repeated often enough, it becomes a powerful “truth.”
The Best Coin-Flipper in the World
Once upon a time in a faraway land, coin flipping was hot. In fact, the biggest reality show on TV was Heads or Tails? Every week, everyone across the nation would tune in to see which coin flipper would win. At the beginning of the season, 1,000 participants tossed their coins in the air and called heads or tails. That first week, half the contestants were wrong, so there were only 500 on the show the next week. Half of those remaining contestants called their flips incorrectly, so the next week's episode featured only 250. On and on it went. Everyone had their favorite flipper, and would watch each week to cheer on their champion. Finally, after a tense contest between the last two contestants, one person called his flip correctly and was declared the winner. By that time, he had predicted heads or tails correctly 10 times in a row.
The entire nation—millions of viewers—thought the winner must have some extraordinary skill to call the flip correctly every time. The Heads or Tails? winner, because of his success, also believed in his own prowess. He was so sure of his remarkable abilities that he went on tour, explaining to all of his adoring fans where to put the coin on their hands, how to use the right amount of pressure in the flip, and how to take the room temperature into account. Everyone listened to this extremely skilled person. After all, he called the flip 10 times in a row; of course he knew what he was doing. Right?
That 19-year period from 1981 to 2000 enabled buy-holders to be expert coin flippers. Everyone (including themselves) thought they were geniuses, when in reality they were lucky. They happened to be the ones who tossed the coin 10 times in a row and called the flips correctly, but it wasn't talent: It was a rising tide that lifted all boats.
Unfortunately, now they believe in their prowess. I recently saw an interview where John Bogle, the founder and retired CEO of the Vanguard Group, said he thinks there will be two major 50 percent bear markets in the next decade. He basically said that's why you should buy and hold, because when the decade is over, you should have more money than at the beginning of the decade. What he believes can be true: for example, your portfolio was higher in 2013 than it was in 2000 if you had bought and held. But would you really want to suffer through the bear markets of 2000 and 2008 just to have slightly more money than you started with? And would that be a good reason to endure two more 50 percent bear markets over the next 10 years? In my view, that makes no sense. After all, there is no guarantee that the market will come back. Betting your retirement on the hope that the market will recover all of its losses during your lifetime is not a good financial plan, as we will discuss later on.
And is it any coincidence that Bogle, the mutual fund king, is a firm believer in buy-hold? Could Bogle be drinking his own Kool-Aid? Buy-hold worked for the mutual funds because they were in the right place at the right time during a long-run bull market. We can't rely on that.
The Famous Scene in The Deer Hunter
If you ever watched The Deer Hunter, you probably remember the Russian roulette scene. Robert DeNiro and Christopher Walken played two POWs who were forced by their Vietcong captors to play the deadly game. I recently read a discussion of the scene that included the answer to the question: How long could someone survive playing Russian roulette?
Traditional Russian Roulette is played with a single bullet in a six-shooter revolver. Someone spins the cylinder and slaps it closed. The player puts the gun to his head and pulls the trigger. He has a one-in-six chance of shooting himself, which means that mathematically, he'd live to tell the story about 83 percent of the time. Not bad odds, if the stakes weren't so high.
But the more often he plays the game, the more the odds work against him. In fact, if the game were played 100 times, the odds are that he would encounter a live bullet (and death) 17 times.
You may remember that in the film, DeNiro's character insisted on playing with three bullets in the chamber as part of a desperate escape plan. He raised the odds of dying to 50/50 for the first player. Both he and Walken survived. Their luck lasted long enough that they didn't kill themselves. That's the kind of luck this last generation had when they invested. But that kind of luck doesn't last. The odds get worse the longer the game is played. The longer you buy-hold, the greater the odds are that you will be exposed to large losses in a major bear market.