Why Warren Buffett's 'Buy-And-Hold' Strategy Is Important

While Friday's missive clearly backed the "active" side of the active vs. passive investing argument, this is not to say that buy-and-hold/hope is universally a bad idea. The problem is that the vast majority of investors simply cannot stomach such an approach. But one reader made an argument that is worth exploring.

Buy-and-Hold Done Right

Below is an unedited comment from a reader of "Daily State of the Markets" on SeekingAlpha.com...

"I come from a family of buy and hold investors. By buying the dividend aristocrats when they were cheap and then never selling them, my mother was able to turn a fifty thousand dollar investment into a portfolio worth over ten million in 40 years. I have been buying and holding the dividend aristocrats since 1970. I am not as good at investing as my mother and made some foolish mistakes by buying an occasional high flyer, but my returns over the long term have been almost as good as hers. Yes, my portfolio lost fifty percent of its value in 1974 and 2002 and 2008. Big deal. Over the long term, I am way way ahead. Buy and hold is definitely the way to go if you want to get rich over the long term."

Quite frankly, the argument presented makes a lot of sense. First off, kudos to this investor for having a strategy. This was one of the key points made in Friday's article. The first step to succeeding over the long-term in the stock market is to have a strategy. And the strategy employed by this reader is a pretty good one.

The "dividend aristocrats," strategy is defined by Standard & Poors as buying companies in the S&P 500 that have increased their dividends every year for the past twenty-five consecutive years. And yes, fans there is an ETF for that: ProShares S&P 500 Aristocrats NOBL.

According to S&P, the average annual return for their Dividend Aristocrat index over the five-year period ending October 25, 2013 was 20.96 percent per year. Granted, this period began near the depths of the "credit crisis" bear market (S&P 500 on 10/24/2008: 908.11) - so the example benefits from "buying low." And it is worth noting that this was generally a bull market period. However, the strategy has beaten the S&P 500 handily.

Over the five-year period ending Friday, October 25, 2013, the S&P 500 cash index has advanced a total of 93.8 percent - or 14.0 percent per year. By contrast, the S&P Dividend Aristocrat index's average return of 20.96 percent per year would have produced a total return of 158.9 percent. Impressive!

Paying the Price - OUCH!

However, as the reader points out, he and his Mom did have to sit through the brutal bear markets that occurred in 1974, 1987, 2000 and 2008. And three of those bears produced losses in excess of 50 percent. So, before you decide to become a long-term buy-and-holder this morning, ask yourself a very important question: Can you live with that?

Be Like Buffett

One way to combat the misery of bear market periods, which, quite frankly, don't occur very often (there have only been three major bear markets since 1980) is to "be like Buffett."

As you are no doubt aware, Warren Buffett is one of the greatest investors of all time. One of the keys to his success (other than buying companies that are undervalued and businesses he "understands") has been to buy when there is blood in the streets. If you will recall, it was Buffett that stepped in and helped prop up Goldman Sachs during the height of the credit crisis debacle. Sure, he was early on the move and GS went a lot lower after his purchase. But in the long run, buying when everyone else is selling has been a fabulous strategy.

A Better Way To Play

The question, of course, is how can the average investor play the game like Buffett does? Obviously, the little guy can't extract high rates of return from Goldman Sachs at the height of a crisis. No, the average investor has to play the game differently.

One way to improve the buy-and-hope strategy would be to understand the historical cycles of the stock market and then to be ready to buy when everyone else is scared and selling. While the following stats are based solely on memory and are NOT exact, it is important to recognize that, on average, severe corrections (a decline in the S&P of 10 percent or more) happens in the stock about once a year or so. Next, recognize that an average bear market (a decline of 18-20 percent) tends to occur every three to five years. And then a major bear market, which produces losses in excess of 30+ percent, happens about (key word) once a decade.

So, the way to beef up the buy-and-hope strategy involving the Dividend Aristocrats would be to focus on "buying like Buffett." For example, one plan would be to:

• Accumulate cash on a monthly basis to be ready for "opportunities"
• Invest a portion of the cash each time the S&P drops 10 percent or more
• Invest an additional amount each time there is "blood in the streets"

In case it isn't obvious, the key to this approach is to have cash available to deploy during corrections and bear markets. Thus, an investor would need to regularly accumulate cash for this purpose and then "deploy it" with discipline.

Nothing is Easy in This Game

However, it is important to recognize that NOTHING is easy in this game. You WILL be very uncomfortable each and every time you deploy your hard earned cash into a market decline. You will also feel VERY uncomfortable when you watch the market go lower after you've made a purchase. In short, one has to understand the game and the game plan being employed.

The key is to understand that this approach isn't about trying to "buy THE "low"... It's about simply "buying low." Over time, adding shares into a decline means that you have more money working during the next bull run. And it is vital to remember that no matter how bad things feel at the time, there WILL be a next bull run!

So, while there are lots and lots of "active" strategies that can beat the market most of the time, adapting a "buy-and-hope" approach using the "Dividend Aristocrats" isn't a bad way to go for investors who only want to get involved in the game when the time is right.

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Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. Overbought Condition
      2. The State of Fed Policy
      3. The State of the Earnings Season

The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 3 months, and long-term as 3 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend: Positive
(Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend: Positive
(Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Positive
(Chart below is S&P 500 daily over past 12 months)

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:

• Near-Term Support Zone(s) for S&P 500: 17240
• Near-Term Resistance Zone(s): 1760

The State of the Tape

Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...

• Trend and Breadth Confirmation Indicator: Positive
• Price Thrust Indicator:Positive
• Volume Thrust Indicator:Neutral
• Breadth Thrust Indicator:Positive
• Bull/Bear Volume Relationship: Moderately Positive
• Technical Health of 100 Industry Groups: Positive

The Early Warning Indicators

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

• Overbought/Oversold Condition: The S&P 500 is overbought from a short-term perspective and is overbought from an intermediate-term point of view.
• Market Sentiment: Our primary sentiment model is Negative .

The State of the Market Environment

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward because different market environments require different investing strategies. To help us identify the current environment, we look to our longer-term State of the Markets Model. This model is designed to tell us when risk factors are high, low, or uncertain. In short, this longer-term oriented, weekly model tells us whether the odds favor the bulls, bears, or neither team.

Weekly State of the Market Model Reading: Positive

If you are looking for a disciplined, rules-based system to help guide your market exposure, check out The Daily Decision System.

Thought For The Day...

"Banking institutions are more dangerous to our liberties than standing armies" -- Thomas Jefferson (1802)

Looking for Guidance in the Markets?

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At StateoftheMarkets.com, our goal is to provide everything you need to be a more successful investor: The must-read headlines, market commentary, market research, stock analysis, proprietary risk management models, and most importantly – actionable portfolios with live trade alerts.

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Wishing you green screens and all the best for a great day,

David D. Moenning
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StateoftheMarkets.com

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Positions in stocks mentioned: none

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