Investors buy and hold at their peril

The chances of Greece not defaulting are negligible to non-existent. The only question is who will take the haircut and what will be its consequences.

Truly, markets now have something to panic about.

In July, European Union policymakers agreed to give the European Financial Stability Facility a stronger mandate. After three months of delay, the parliaments of Slovakia, the Netherlands and Malta have finally got around to ratifying it.

Nevil Shute's On the Beach balefully describes the Australian investor's predicament: one knows a crisis is imminent but one cannot say how or when it will arrive.

This month, with concerns about China growing, the clock ticked closer to midnight. The copper price has fallen more than 20 per cent in the past month. Gold is down 11 per cent.

A return to fundamentals has not brought down just commodity prices. On July 27, the dollar hit US110? but now trades at virtual parity after falling below US94?.

In an environment such as this, a buy-and-hold strategy no longer makes sense. To explain why, consider the chart above.

From 1966 to 1982, the US Dow Jones Industrial Average barely advanced. But between those years it featured 10 cyclical bull and bear markets.

If this is what the future looks like - and we believe it does - a buy-and-hold strategy doesn't make sense.

In typical bull markets, holding on to a stock until it reaches then surpasses fair value before selling is quite possible, sensible even. In sideways markets, when a quick bear market can strike at any time, it's a much less likely outcome.

The answer is not to focus on charts or momentum, both of which reflect share-price action, but to pay even more attention to valuation.

If you have bought a stock worth a dollar for 60?, start selling when the price reaches 90? and sell entirely by the time it hits 95?. That way there's always a margin of safety in your decision to sell, an insurance against a swift bear market.

Hanging on for a dollar or more increases the possibility of a bear market wiping out your gains and losing the opportunity to reinvest in cheap stocks that will compound profits at high rates of return.

That's another reason for selling close to fair value. Frequent bear markets deliver opportunities. Why hang on for another 5 per cent when it's safer and more profitable to buy other, cheaper stocks with a greater margin of safety?

This strategy is based not on timing the market but buying stocks as they become cheap and selling them when they approach fair value.

For Australian investors, many of whom have matured with the wind at their backs, this demands a major but necessary psychological shift.

There are other protections against folly. Placing too much money in one stock is an act of hubris best avoided. Use sensible portfolio limits and ensure your portfolio is diversified appropriately, remembering that proper diversification is not just about the number of stocks you own but the relationship between them.

Finally, you might need to temper your expectations. Returns of 20 per cent a year or more are exceptional, not the norm. In sideways markets, markets might rise 20 per cent one year and fall by the same amount the next. Despite the challenges, a volatile market provides many opportunities to buy low and sell high. Using a buy-and-hold strategy means you won't have the cash to take advantage of it.