I always get excited when changes to the Dow Jones Industrial Average (DJIA) occur.  I don’t really know why.  But you can bet I was glued to my TV when Chevron, Bank of America, and Kraft replaced Honeywell [HON: 42.27, +0.78 (+1.88%)], Altria [MO: 20.77, +0.03 (+0.14%)], and AIG [AIG: 32.77, +3.67 (+12.61%)] last year.  This year, the DJIA has changed yet again, with Cisco [CSCO: 26.13, 0.00 (0.00%)] and Travelers [TRV: 53.57, -0.23 (-0.43%)] replacing GM [GM: 0.75, 0.00 (0.00%)] and Citi [C: 3.82, +0.26 (+7.30%)].

The DJIA is meant to reflect the overall US economy, comprised of a mix of the largest companies in different sectors.  The stock pickers over at News Corp. (who select the Dow 30 components) do a pretty decent job of creating a representative sample of the US economy.  What the folks over at News Corp. are not good at is making money in the stock market.  If you’re looking for a successful investment strategy, don’t look to the DJIA.

The DJIA tends to change whenever one of its components performs badly…usually very badly.  Those companies that are struggling to survive get kicked out of the index, replaced by a strong company with strong historical growth.  AIG got kicked out after the bailout fiasco, while GM only got kicked out after declaring bankruptcy.  These companies were replaced with companies that performed well compared to the companies they replaced, which is reflected by their stock prices.  When Kraft replaced AIG on September 18, it was trading within 10% of its five-year high.  Cisco was significantly outperforming the S&P 500 when the announcement to replace GM was made.

The issue with this index is that it buys high and sells low.  When companies become market leaders, after years of considerable growth, they become eligible for the index, while shrinking companies in the index find themselves on thin ice.  Fortunately, the folks over at News Corp. aren’t interested in buying low and selling high, they’re interested in maintaining an accurate reading on the economy.

You on the other hand are interested in making money…by buying low and selling high.  One word of advice for you investors out there is to follow the exact opposite strategy of the DJIA.  Instead of buying companies whose stock prices are climbing higher, you should be looking for healthy companies that have depressed stock prices.

Stock prices are like roller coasters.  Initially they go higher and higher, but at some point they come back to earth.  Look at any five year history of a company’s stock price and you’ll see that.  Stocks never continually go up.  They go up for a while, then pull back a little bit, then march on.  The key is to capitalize on the moments when those stocks pull back.

When we see a stock start climbing the market roller coaster, we get overcome with emotion.  We think that it will continually climb higher and higher, and if we don’t hurry up and buy it now, we’ll end up paying more for it later.

Unfortunately, that’s rarely the case.  We jump when we see a stock take off, and end up buying just as the roller coaster runs out of steam.  The stock price falls in value, we panic, and sell at a loss.  Our excitement over the prospect of an ever climbing stock price causes us to lose money.

Now imagine that you bought a stock when it was on its way down the market roller coaster.  Maybe you bought Apple [AAPL: 223.02, +3.94 (+1.80%)] in December of 2000, or Burlington Northern Santa Fe [BNI: 100.21, 0.00 (0.00%)] in November of 2002.  These stocks got too hot too fast, and both suffered sharp drops.  If you waited for these drops and held onto these stock for the next few years, you’d have done very well.

This seems really easy to do.  Find a stock you like, watch it, and wait for a few bad days to buy in.  But once you actually find that stock, it becomes very difficult to stand by and wait.  It may take a few weeks or even months, but waiting for those pullbacks will eventually pay off for you down the road.

So don’t be like the Dow.  Don’t buy in when a stock’s doing awesome.  Wait for it to pull back, and then dive right in.

-Nick Klein

Disclaimer: None

Buy and Hold is not dead, and I’m on a mission to prove it.  Buy and Hold has worked brilliantly for decades, and it will continue to do so in the future.  The stock you bought in 2007 is worth less now than what you bought it for?  Oh boohoo, go cry me a river…somewhere else.  The economy has peaks and troughs, and we’re in the middle of one of the more serious troughs since the Great Depression.

Buy and Hold has worked wonders for Warren Buffett for years.

The pundits will claim that you can’t buy a stock in year X, leave it alone, and sell it many years later in year Y for a profit.  These people cherry pick companies to make their points.  They find the few companies in the US economy that have failed so miserably that you’d think they were run by the very same people who run the Social Security Administration.  General Motors is a favorite, along with General Electric (which is a misnomer, as we’ll prove below).

To prove that Buy and Hold is not dead, I logged onto Yahoo! Finance and randomly selected 35 components of the S&P 500.  I reviewed these companies’ 20-year returns from May 21, 1989 through May 21, 2009.  I selected the following companies:

Vulcan Materials [VMC: 45.69, -0.26 (-0.57%)], Applied Materials [AMAT: 12.29, -0.07 (-0.57%)], General Electric [GE: 16.49, +0.22 (+1.35%)], Reynolds American [RAI: 52.63, -0.49 (-0.92%)], Deere & Co. [DE: 59.28, +0.08 (+0.14%)], Freeport McMoran [FCX: 79.76, -0.86 (-1.07%)], Zion’s Bancorp [ZION: 19.26, +0.33 (+1.74%)], Home Depot [HD: 31.68, -0.04 (-0.13%)], Coca-Cola [KO: 54.18, -0.28 (-0.51%)], Halliburton [HAL: 30.91, -0.50 (-1.59%)], Alcoa [AA: 13.67, -0.11 (-0.80%)], Apple [AAPL: 223.02, +3.94 (+1.80%)], Microsoft [MSFT: 28.80, +0.17 (+0.59%)], Archer Daniels Midland [ADM: 30.51, -0.06 (-0.20%)], Pepsi Bottling Group [PBG: 0.00, N/A (N/A)], Johnson & Johnson [JNJ: 64.27, +0.07 (+0.11%)], Consolidated Edison [ED: 43.66, -0.13 (-0.30%)], Oracle [ORCL: 24.88, +0.18 (+0.73%)], Target [TGT: 52.86, -0.62 (-1.16%)], AT&T [T: 25.56, +0.28 (+1.11%)], IBM [IBM: 125.55, -0.86 (-0.68%)], Wal Mart [WMT: 54.06, -0.09 (-0.17%)], Pfizer [PFE: 17.23, -0.12 (-0.69%)], Boeing [BA: 67.79, +0.55 (+0.82%)], Goldman Sachs [GS: 168.85, -0.99 (-0.58%)], Union Pacific [UNP: 70.84, +1.35 (+1.94%)], Qualcomm [QCOM: 38.68, -0.11 (-0.28%)], Conagra Foods [CAG: 25.24, 0.00 (0.00%)], Schwab [SCHW: 18.97, -0.07 (-0.37%)], Gannett [GCI: 16.06, -0.10 (-0.62%)], Newmont Mining [NEM: 51.17, +0.11 (+0.22%)], Loews [L: 37.44, -0.10 (-0.27%)], NVR [NVR: 744.48, -8.04 (-1.07%)], Bank of America [BAC: 16.80, +0.06 (+0.36%)], and United Tech [UTX: 71.78, +1.02 (+1.44%)].

Before continuing, go ahead and guess how many of these companies currently trade lower than they did in 1989.  Five?  Ten?  Fifteen?  Nope, wrong!

Of our sample of 35 companies, only one finished lower over this 20-year period, Gannett.  Gannett was off nearly 50% from its 5/21/89 price.  Compare this to several companies like Microsoft and Oracle which were up approximately 5,000% over the same period.  Even General Electric’s stock price increased since 1989 by a whopping 403%.

This sample is less than 10% of the overall population, but I believe that others would find similar results if running the same random sampling techniques.  Very few companies have seen losses over a 20-year period.

After running this analysis, I still wasn’t happy, so I pulled ten of these stocks (including Gannett) into one portfolio (each at 10%) and reviewed how the portfolio would perform over the same period.   I chose Microsoft, United Tech, ConEdison, General Electric, IBM, Conagra, Gannett, Loews, Schwab, and Bank of America.  Creating this portfolio in 1989 and leaving it alone until 2009 would have yielded 403%, compared to the S&P 500 return of 177%.

403% is an outlier, and we’d expect a combination of this and other analyses to bring the average to the historical return of the S&P 500, but this analysis is sufficient to prove our point that buying and holding a diversified portfolio of 10-15 stocks within different industries will provide long-term investors with a comfortable investment.

I’d like to stress that it would take a diversified portfolio to achieve these results.  Buying and holding one or two stocks leaves you open to substantial and reckless risk.

This takes us to our next point. The average American doesn’t need to get bogged down by spending hours upon hours deciding which 10-15 stocks to hold, and whether they’re all in different industries.  Simply investing in a few well diversified mutual funds or exchange traded funds (ETFs), especially those that track a well-known index, will provide the average investor with a solid long-term return.

It’s not very difficult to Buy and Hold and make money, but these pundits write and talk on newspapers and TV shows about the death of Buy and Hold in such a frightening manner that regular investors panic and abandon this strategy.  These investors then either attempt to time the market with little knowledge of how markets work, or simply avoid the market altogether and invest their money in 2.00% CDs for the rest of their lives.  This is a big mistake, since there hasn’t been a single 30-year period where the S&P 500 has lost value.

If you’re reading this and aren’t sure where to put your money, stick it in a few low cost mutual funds or ETFs that track major indices like the S&P 500, Russell 2000, or MSCI Emerging Markets Index and leave it alone.  If you have a little more interest in the market, go ahead and piece together that diversified stock portfolio.  These pundits are wrong.  Buying and holding is alive and well, and as long as the US and world economies continue to grow, you’ll see your portfolio grow along with them.

-Nick Klein

Disclaimer: The author is long KO, ED, MSFT, and JNJ.