Investing Basics

Understanding Investments: Buy and Hold Means Accept Company Loss, Wait Patiently for Recovery

There is a common misconception that investors must sustain losses in order to enjoy the fruits of the market. Investors are told that downturns are inevitable, that they can't time the market, and in order to make sure they don't miss the big gains, they have to hold on and ride out downturns—even if those downturns become major crashes. For investors interested in truly understanding investments and the markets, however, a break in this conventional thinking is required.

The Endless Cycle of Highs and Lows

Buy-and-hold investing, which is based on the fear of missing rallies, advises investors to hold onto investments no matter how bad things get. No matter how severe the loss, a recovery is right around the corner, and those losses will be recouped when the market rebounds.

Essentially, investors who subscribe to this philosophy must accept losses as part of the path to achieving gains. But what if investors exited declining investments before the onset of a major crash? Instead of moving from high to low to high, would it not be more profitable to move from high to new high?

When you exit before the crash, you can potentially capture the recovery for additional profit that others need to merely recover.

Breaking the Cycle

In a hypothetical crash, consider a market at 1,000 that crashes to 500 and then climbs back to 1,000 over the course of five years. Buy-and-hold investors are told stoically to accept losses of 50 percent and wait patiently for half a decade or more, just to get back to where they were and have the chance to make money once again.

It is not necessary to tolerate this cycle. Investors do not have to endure steep losses just for the chance to achieve hypothetical gains.

In this hypothetical crash example, not all investors would have ridden out the downturn. What if some investors had watched their shares rise to 1,000, sold when the decline began, and then bought again at 500 or say 600 when the market was on the way back up to 1,000?

Some investors went nowhere while others got ahead.

The idea that investors must suffer losses in order to achieve gains is promoted heavily by some in the financial industry. This is the backbone of the buy-and-hold philosophy, but there is no evidence to support its legitimacy as the best strategy. The talk can sometimes be supported by unrelated data, appeals to fear, and a host of other fallacy-ridden arguments. Investors can instead seek to buy low, sell high and try to mitigate major losses in between—which is not possible if they never sell at all.

It is not possible to determine the top or the bottom of the market. Investing in the market involves risk, including fluctuating prices and the uncertainty of return. There is no guarantee that the investment strategy discussed will be successful.

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