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  • Buy and hold works great in bull markets, but it's risky for individual stocks in bear markets.
  • The S&P 500 is a momentum index, so approaching it with a buy-and-hold mindset is different than doing so with individual stocks.
  • Buy and hold can turn into buy and forget, leaving you with a significant drawdown to overcome.

Buy and hold is among the most popular mantras during bull markets. It's easy to understand why. Bull markets are forgiving, so buying dips in even the sketchiest stocks can pan out. Furthermore, tailwinds from mutual fund inflows allow stocks to keep hitting new highs, making it less critical to time exits. In short, it pays to hang on to stocks tightly when markets cooperate.

However, bear markets expose the weaknesses associated with a buy-and-hold strategy. Investors, certain that bull market behaviors will continue, ignore falling prices, unwittingly turning buy-and-hold into buy-and-forget. As a result, they get trapped in former high flyers that have fallen to prices from which they're unlikely to recover losses for years, if ever.

Treat stocks and “the market” differently

One big mistake investors make when it comes to the buy-and-hold approach is extrapolating historical returns of major market indexes, such as the S&P 500, to individual stocks. All it takes is looking at a long-term chart of the S&P 500 to conclude that a set-it and forget-it approach to the market can pay off.

However, assuming that's also true for individual stocks is risky. 

The S&P 500 is a momentum index because its holdings are everchanging to reflect the country’s biggest companies by market capitalization. If a stock’s price appreciates enough, it will be added to the index; if it declines enough, it will be removed from it. This momentum approach is why the S&P 500 sold stocks like Polaroid and Sears many years ago. It’s also why Tesla is its 4th largest holding.

As a result, buying and holding the S&P 500 means you'll always own the market’s biggest stocks, whatever they may be. In short, the index does the heavy lifting of deciding what to buy and, importantly, what to sell for you. 

If you own individual stocks, those decisions fall on your shoulders. It can be a heavy burden to carry in a bear market because many stocks decline multiples worse than the market itself. If you’re not careful, a failure to prune stocks that no longer earn their place in your portfolio can result in a steep hill to climb back to prior highs.

For example, consider Zoom Video  (ZM) , Teladoc  (TDOC) , Roku  (ROKU) , and Redfin  (RDFN) . Investors championed these stocks during the COVID lockdown, and arguably, it was easy to paint a bullish thesis for buying and holding them. But unfortunately, each has declined by over 85% from its peak, creating a significant headwind for portfolios. Remember, returns aren’t symmetrical. Each case will require a rather herculean effort to recover former highs. For instance, Redfin is down 92%, but it will need to rally a whopping 1,214% for investors who bought the top to break even.

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Sure, maybe those stocks will rally that much or more in time. However, it could take years or decades for that to happen. For example, during the dot-com bubble, consider Cisco Systems  (CSCO) , one of the highest-flying technology stocks. It fell from $70 to about $8 per share between 2000 and 2002, or roughly 88%. It’s been over 20 years, yet it still hasn’t recaptured its peak price. The same is true for other 90’s Internet darlings, including Intel  (INTC) . Moreover, plenty of second and third-tier technology stocks wound up in bankruptcy court following the Internet bust.

Another problem with buy and hold is that it assumes you have an unlimited supply of new money to invest in fresh ideas. That may be true for those of us still working. However, it may not be the case for those investing an inheritance or a lump-sum retirement payout. In cases where the initial investment is a fixed amount, failing to cull the herd of stocks held in portfolios means an inability to add the next big winner. For example, suppose you inherited a lump sum in 2000 and bought-and-held names like Cisco and Intel. Without selling, how would you have been able to invest in Facebook when it IPO’d in 2012 or Tesla when it went public in 2010?

Furthermore, a strict buy-and-hold approach can significantly increase your volatility because of concentration risk. For example, you may have only invested 5% in Amazon, but it could have conceivably grown to a much more significant percentage of your portfolio. If so, the fact it has declined by one-third in less than a year may mean it’s having an outsized impact on your account balance. Yes, that can be OK if your time horizon remains long, but if you’re in retirement and you’re drawing down your account to pay bills, it could create some uncomfortable headaches.

The Smart Play

There’s never been a time when it didn’t pay off to buy and hold the S&P 500. Those with a long enough horizon have made money regardless of War, runaway inflation, bear markets, terrorist attacks, banking failures, and a pandemic. Its impressive track record is due to its composition regularly changing. For perspective, only seven of the top 25 members of the S&P 500 in September 2001 remain on that list today.

Since the S&P 500 is a momentum index, I’m a fan of buying and holding it as a core portfolio position. I’ve recommended to Smarts readers all year that bear markets are a great time to increase monthly contributions via retirement accounts to funds tracking the index. Doing so means you’ll own more shares at a lower average cost, putting you in the perfect position to profit from the next bull market.

It’s a different story for individual stocks. As we’ve seen this year, individual stocks can fall further than indexes during a bear market, creating a drag on performance. In addition, buying-and-forgetting exposes you to concentration risk, and absent new capital, it can prevent you from buying the next bull market’s winners, further hamstringing results. Therefore, it is key to adopt rules to help determine when it’s time to scrap a poor performer.

To avoid the risk buy-and-hold morphs into buy-and-ignore and buy-and-forget, include an exit strategy (and stick to it!) as part of your thesis before placing the trade. Similarly, rules governing leverage and position size can also help you avoid some buy-and-hold pitfalls. Overall, stashing a company away for the long haul isn’t a bad idea, especially during a bear market, just make sure that your thesis stays intact and you have a plan for when to sell.

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