THE TRUTH ABOUT BUY- AND-HOLD

July 2010Online Trading AcademyTampa, Florida – (813) 933-4350tampa@tradingacademy.com

Investing is dead

The Truth about Buy-and-Hold

On May 6th, 2010, the Dow dropped 740 points in 17 minutes, and then rebounded completely in 22 minutes. Over the next few weeks, the market sank to the low of the “Flash Crash” three times before plummeting even further, devastating the portfolio of the Buy-and-Hold investor.

In the crash of 2008, retirement accounts lost over $2 trillion, and the Dow lost 55% of its value, requiring a 120% gain for long-term investors to merely break even. The market managed to regain only half of that before reversing and continuing its downward slide.

After the Tech Bubble burst in 2000, and the NASDAQ dropped 78% in 2.5 years, investors needed a 360% return to reach break-even. However, even after five years on the rebound, the NASDAQ struggled only to the halfway mark before revisiting the lows of 2002.

The markets are becoming more volatile on both axes: price and time. Price is experiencing wider swings up and down, while the time required for trades is compressing. With High Frequency Trading (legal “front running”) and global, 24-hour trading growing in popularity, this volatility should only increase. These conditions do not bode well forBuy-and-Hold, long-term investing.

The Source of the Problem

The popularity of Buy-and-Hold investing is the product of the rampant greed of both Wall Street and the inexperienced investor. Not surprisingly, the results for Wall Street have been very good; not so for the individual investor.

Buy-and-Hold investing in its simplest form is the purchase of an “undervalued” asset followed by an undetermined holding period, generally several years to decades, with

Page 1

Investing is dead

the expectation that the value will continue to rise indefinitely. Some may disagree with this definition, but without specific entry and exit prices and/or time frames in mind before you invest, there is little room for debate. Talk about a risky endeavor!

Wall Street likes to sell this strategy because its business model is asset aggregation. In other words, the more assets it has under management, the more profit it makes. In many cases, much of the Wall Street profit comes from leveraging your account and aggressively trading it by timing market moves. (By the way, this skill, trading and timing asset moves, is one you’ve been tricked into believing you are unable to learn and successfully practice, a myth we’ll debunk in this white paper.)

Individual investors subscribe to this strategy because it promises passively obtained, desirable returns i.e., double your money every seven years or less! Who doesn’t want double-digit returns with no effort? Of course, the question remains: “Just who is consistently getting double-digit returns with Buy-and-Hold?”

Wall Street’s proof that Buy-and-Hold is your best strategy is clearly visible on its stock charts. These charts reflect the trend: prices moving from the lower left to the upper right. Why buck a trend like that? If you look at the chart on the right, you’ll see that the 20 year period ending in 2000 represented an incredibly effective time frame for Buy-and-Hold.

However, an accurate comparison cannot be made without taking inflation into account. When we do this, the outlook is much different. When looking at the chart below, even an armchair economist can see we’re little better off than 1966!

Page 2

Investing is dead

What’s Really Happening

Markets move in stages, sometimes predictably so. However, bull markets are not immediately followed by bear markets and vice versa. There is a period of indecision that occurs before prices reverse trend. The chart below depicts the way a professional investor views market stages.

Stage 1 is Accumulation – professionals start buying at “wholesale” prices. The novice is too fearful to enter after a steep drop.

Stage 2 is Mark Up – professionals accelerate buying early in this stage driving the greedy novice to buy into the Bull Market at higher and higher prices.

Stage 3 is Distribution – professionals start selling their inventory at “retail” prices. The novice continues to buy.

Stage 4 is Mark Down – As prices fall, fear takes over and the novices panic out of their positions at a loss. Professionals attempt to drive prices down even further by short selling.

Page 3

Investing is dead

The table at right shows the Dow’s annualized rate of return during each decade since 1920. Double-digit returns were reached less than half the time. Worse, in the decades that didn’t reach double-digits, the returns were less than the risk-free rate of return offered by Treasuries (see highlights). Clearly, luck is an essential component in the Buy-and-Hold strategy.

The cyclicality of the data is evident. However, an interesting pattern emerges. With the exception of the 1980s and 1990s, every boom decade was followed by two miserable decades. The last decade, the 2000s, was not only miserable, but offered negative returns. The only other era of negative returns was during the Great Depression. So, will the next decade look like the 2000s, as the historical pattern suggests, or will it look like the 1990s – as Buy-and-Hold investors are hoping? And are you willing to bet your retirement on predictions?

While enlightening, using calendar decades is somewhat arbitrary and not demonstrative of most investors’ market entry and exit timing. Here’s a better analysis: The rolling 12-month-average rate of return. With this analysis, you can choose your entry and exit times on the chart below and see the resulting rate of return for as long as you “held on.”

Rolling 12-month ROR from 1930 to Present

Page 4

Investing is dead

This view certainly doesn’t support the Buy-and-Hold strategy. In the last 80 years, there were 41 up and 39 down periods for the rolling 12-month-average rate of return. Looking at it from a monthly perspective, the Dow has been up 58% and down 42% of the time since 1920. The odds of having a profitable Buy-and-Hold event are no better than a coin toss.

Yet another conclusion we get from this data is the relative speed of up versus down markets. Our rate of return analysis shows a 50/50 chance of making money with Buy-and-Hold (assuming a randomly timed entrance into the market). We also know that rising markets take longer to mature, and that markets fall faster than they rise (see the frequency of “up” markets versus “down”). Emotions are the key. Price moves less from intrinsic value changes than from human emotion and perception. Greed and fear are the dominant emotions reflected in the market, and neither can be accused of inspiring sound thinking.

During the Roaring ‘20s it took 97

Page 5

Investing is dead

months to gain 504%. However, all was lost in only 34 months (about one third of the time).

Incidentally, here’s another math trick that fools investors. Even though the decline in the crash of ‘29 was a whopping 89% at the low, it seems almost acceptable given the monstrous 504% gain that preceded it. This same information presented on a graph looks much different. You will notice that to return to the previous high, investors would have needed an 852% return! In simpler terms, a 50% decline requires a subsequent 100% return to break even. And how often does anyone experience a 100% return?

Here is a current example of the same phenomenon: 60 months to peak, 17 months to bottom. Compare the two charts and you’ll see the slope of the rise and fall is much steeper today. This is further proof that volatility is increasing via time compression as well as price range.

Given the facts that markets…

Are cyclical Fall faster than they rise Persist sideways for years, sometimes decades Rise relatively smoothly less than half the time

… Buy-and-Hold should be named Buy-and-Hope, but that’s bad marketing.

The skeptics might say that using the market itself to judge the effectiveness of Buy-and-Hold is arbitrary. What about the fact that individual stocks are carefully selected and therefore will improve upon broad market performance? Says who?

The average actively managed fund has returned an average of 2% less than the market itself since 1960. Vanguard founder John Bogle said,

Page 6

Investing is dead

“Our hypothetical fund investor has earned $1,170,000, donated $700,000 to the mutual fund industry, and kept the remainder of $470,000. The financial system has consumed 60% of the return, the fund investor has achieved but 40% of his earnings potential. Yet it was the investor who provided 100% of the initial capital; the industry provided none.”

Why such a poor performance from a talented, educated, well-financed, resource-rich group? There are three reasons; rules, fees and scale. Most funds are not allowed to short sell or hold excessive cash. As funds grow very large it becomes more and more difficult to buy and sell the increasingly larger position size. Individual investors don’t have these constraints and should perform markedly better than managed funds, even with Buy-and-Hold.

The Trading Alternative

If long-term investing is dead, what should you do? You should learn to actively trade the markets like a professional. Novice investors are passive. They place their bets and hope. More often than not, they lose. Professional traders think like businessmen. They have specific buy and sell points planned in advance, and create profits on a regular basis by doing so.

Trading is a frame of mind, not a time frame. Many people think that trading means sitting in front of a computer all day buying and selling at lightning speed. Well, that is a style of trading, called momentum or day trading, but that’s not what most traders do. Some traders look for short-term moves, called swing trades, keeping their trades open for days or weeks. Others have a longer outlook, called position trading, keeping their trades open for months, even years. Trading is “time frame” independent. You choose which time frame works for your lifestyle and goals.

Regardless of time frame, what all successful traders have in common is a Trading Plan. And that plan includes entry and exit timing, among other important rules. Traders know in advance how much they might lose or gain on every trade. They plan their trades to make a profit. And when they lose, they try to lose very little on a relative basis. In fact, in the business of trading, losses are the equivalent of expenses in any other business. And just like any good business owner, you endeavor to keep your expenses low. Trading isn’t gambling; it’s a business and good business practices apply.

Now compare this one simple concept - clear, pre-planned entry and exit targets – with buying and holding. While a buy-and-holder is riding stock prices up and down, a skilled trader is using sophisticated risk management and market-timing techniques, including volatility-based position sizing; trailing stop losses; profit targets; scaling in; scaling out; hedging with futures & options; pairs trading; and much more. You can use these too. You simply need to learn how and when.

Page 7

Investing is dead

A Simple Winning Strategy

Let’s look at a simple position trading strategy (intermediate term) and compare the results to Buy-and-Hold. Before we get started with the analysis, however, it’s important to understand the foundation all successful traders use: The Trading Plan. Trading is a business. As such, you need to create a plan that has rules for what you trade, how you’re going to trade, and most importantly, when you’re going to accept a loss or earn a profit.

Let’s assume you’re working full time and golfing when you’re not. You only want to invest an hour each week in your trading. The outline of your trading plan might look like this:

1. What to trade? - Most of a stock’s move is caused by the market itself, not the company’s performance. So, let’s save plenty of research time and trade only the market itself, the S&P 500. We’ll use the Exchange Traded Fund (ETF) symbol SPY (this ETF performs just like the index itself). Our research work each month is now limited to one asset and can easily be accomplished in less than an hour.

2. How to Trade? – Markets go and up and down and we want to profit in either direction, so we’re going to design a simple trading system that keeps us always invested. We’ll enter long trades in bullish markets and short trades in bearish markets. If our investment account is an IRA, instead of shorting SPY in bearish markets, we’ll buy the inverse ETF “SH” (which goes up when the market goes down) because short selling is prohibited in most IRAs. The result will be very similar. Our strategy for entries will utilize a simple trend-following technical indicator called a moving average.

3. How to Profit? The third component of our basic trading plan is the most important: Money Management. We’re going to use an extremely powerful money management plan that many successful traders use. Here are the rules:

a. We’ll use a protective stop loss order when we enter a trade. This is an order that gets us out of the market if it’s going against us. We don’t want any monster losers.

b. Once the trade does move in our direction, we’ll use a trailing stop loss based on the market volatility at the time. This exit will “trail” price as it goes in our direction, allowing us to capture long moves and lose minimal amounts when direction changes. We base this exit on volatility so that we’re always in harmony with market conditions as they change.

c. We’ll compound our gains so that our equity grows quicker. Note that this is beneficial only when buying an asset for less than you sold it. Since

Page 8

Investing is dead

we’re going to be profiting from market declines, thereby having more equity and a lower share price, our long entries after profitable short trades will boost our position size and return handsomely.

A picture often tells the story best. In the weekly price chart below, the blue line that scrolls up and down across the chart is called a Moving Average; it represents the average closing price of the preceding 52 weeks. This particular chart reflects the application of our winning strategy over 16 years between 1995 and 2010. Our premise was that while price was trading above its 52-week moving average, the market was bullish and we remained long. If price was trading below its 52-week moving average, the market was bearish and we remained short.

How did we do? Very well for an hour of “work” each week. In fact, over the past 16 years, only 13 trades were generated. The $10,000 invested in January 1995 grew to $57,417 in 2010. That’s an annual return of 12%. Only 60% of our trades were winners, but because of the risk control in our money management formula, the average winner was $28 per share, while our average loser was only $7.30 per share.

What about Buy-and-Hold? Well, your $10,000 would have bought 215 shares in 1995. As of March, 2010, that position was worth $22,192. That’s an ROI of about 5.3%, which is not much better than Treasury Bills.

Now, keep in mind there’s much more to a winning trading strategy than this example. But the purpose of this white paper is not to deliver the Holy Grail of systems for you to use “as-is.” The purpose is to demonstrate that even the simplest trading concepts, when applied properly, can trash Buy-and-Hold.

Attend our half-day complimentary Power Trading Workshop.

It is vitally important that you develop and follow a trading and investing plan that is tailored to your specific financial goals, risk tolerance and lifestyle. More importantly,

Page 9

Investing is dead

you need the knowledge, skills, tools and resources to keep that plan updated going forward. Online Trading Academy would like to help you create that plan. You are invited to attend a complimentary half-day class in which you will learn…

Volatility-based risk and trading strategies How to safely short sell and earn fat returns when the market drops How to buy stocks at “wholesale” prices, below the current quoted price How to adjust your trading style to the market momentum The 7 Pillars of Trading, contained in every great trading plan Entry and exit timing tactics that will improve your returns up to 2x Plus, you’ll witness a live trading session with one of our professional traders.

You’ll watch as we trade live and call out the market action…

This complimentary half-day class is limited to only 15 attendees for personalized attention to your trading and investing questions. Contact us for the current schedule at:

Tampa, Florida: (813) 933-4350, Tampa@TradingAcademy.com

Our Heritage

Online Trading Academy’s roots can be traced back to 1997, as one of the largest trading floors in the U.S.A., with 180 traders averaging half a billion dollars in daily transactions. To improve results, managers and the top traders offered daily coaching sessions to under-performing traders in how to trade more consistently and profitably.

In 2001, we shifted our focus to solely providing education. Today, we have a community of over 10,000 students that have learned to trade with the skill and confidence of professional traders.

We offer professional instruction in all of our state-of-the-art teaching facilities around the world. Classes cover a spectrum of trading styles and asset classes, including day trading, swing trading, position trading and investment theory for stocks, ETFs, options, futures, and currencies.

Most of the classes we teach offer 100% tuition reimbursement from our broker/dealer partners. And we are unique in integrating live trading in class, with all trading expenses (losses and commissions) paid by us.

As an Online Trading Academy student, you’ll become part of a community of active traders committed to success through continuously improving their professional skills. In fact, our live classes offer free “retakes” for life, giving you the opportunity to really “get it” and stay abreast of market changes going forward.

Page 10

Investing is dead

More Free Trading Resources

1. Join our free trading Meetup Group, Tampa Bay Market Traders, to share trading successes, challenges and Q&A with an Online Trading Academy Instructor. Register at www.meetup.com/TampaBayMarketTraders/.

2. Subscribe to Lessons from the Pros, Online Trading Academy’s weekly e-newsletter written by the best trader/teachers in the industry.

3. Listen to Power Trading Radio at http://www.tradingacademy.com/radio/ every weekday from 6pm to 7pm EST. You’ll hear great interviews and learn the inside tips and tricks pro traders use to win consistently.

This document is for informational and/or research purposes only. No offer or solicitation to buy or sell securities, securities derivative or futures products of any kind, or any type of trading or investment advice, recommendation or strategy, is made, given or in any manner endorsed by TradeStore, LLC, Online Trading Academy and/or any of their affiliates or employees. Past performance, whether actual or indicated by historical tests is no guarantee of future performance or success. There is a risk of loss in trading. Trading is not suitable for all investors. There is a possibility that you may sustain a loss equal to or greater than your entire investment; therefore, you should not invest or risk money that you cannot afford to lose.

Copyright © 2010 TradeStore, LLC. All Rights Reserved.

Page 11