Kuta Beach

Kuta Beach

Thursday, 12 March 2009

Critique of Buy and Hold

On the train to work today I was listening to a Bloomberg podcast with Zvi Bodie. He claimed that the biggest myth out there in the investing world--a myth that has plunged many mom-and-dad investors into poverty--is if you buy diversified shares (e.g. through a stock mutual fund or stock index fund) and hold for the long run then somehow, simply by holding for a long time, risk is eliminated. Zvi claims that this goes against financial theory and cannot be.

More return means you take on more risk. This is a fundamental law of financial economics. If this were not the case (e.g. if stock returns in the long run were no more risky than Treasury bond returns) then arbitrage will ensure that this will no longer be the case. Bonds will give you, say, 5% in the long run. Many claim stocks will give you 10% in the long run, beating bonds.

If stock returns are double the return of bonds in the long run and just as safe, in an efficient market, individuals would perform risk arbitrage, buying bonds from investors, using those bonds to buy stocks, wait for a long time, get 10% returns from those stocks, sell those stocks, pay back 5% in bonds to the bond investors, and then pocket 5% profit. In an efficient market where participants have information about risk, this cannot happen.

Stocks then must be riskier than bonds and the long run does not diminish the risk.

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