It only works if you first do the most important thing in investing and that is to only buy when prices are low and only sell when prices are high. Any investment can be good if bought at a low price and a good quality company can be a bad stock investment if its price is too high. A component of buy and hold strategy should be to only buy enough risky assets that you can afford to hang onto during a crash. That way you are not forced to sell at the bottom due to a personal crisis such as fear or unemployment, etc. This means having a balanced portfolio with plenty of cash or short term quality bonds (dry powder) to weather the storms.
Why buy and hold investing is popularInvestors and experts have become frustrated with trying to forecast the markets so they are tempted to seek a solution. They notice that after many decades the market continues to rise so they are tempted to think that a buy and hold strategy of refusing to sell during a crash is a good idea. While holding on during a crash is good idea, that idea alone is not enough to become successful. In addition one must buy only when the price is low. And one must strive to avoid loss, which is more important than seeking large gains. If you buy stock for $100 and it goes down 50% and then goes up 50% then the stock is worth 75% of what you paid so you lose 25%.
How to determine when a stock is priced low?A stock is not low priced simply because it is at historical lows. The old highs could be a false benchmark created by a bubble or a one-time lucky break that will not reoccur. The key to valuation is to not get too excited about balance sheet items such as assets or equity or book value. Instead look at income statement items. Use a five or ten year inflation adjusted average and filter out one-time or unsustainable items to get a clean data stream of the company’s income. Then find a multiple, like a P/E ratio, to estimate the value. The reason income is important is because it gives you have a constant flow of data points of sales and expenses over many years and it is really hard to make a large company grow faster than the economy (assuming it doesn’t purchase other companies), so the income statement is far more powerful and reliable than the balance sheet. A balance sheet contains assets that can suddenly become obsolete or decline in value or become illiquid but the liabilities are still there. A balance sheet has far few data points than a long term flow of five years of sales data.
In addition, the reason a company has value is because investors want the earnings yield of the company. Rarely do people buy a company so they can develop allegedly dormant undervalued real estate holdings or sell off old capital equipment at a profit. By the time someone puts into motion a plan to develop dormant corporate asset holdings the economy could go into a recession and the new debt and expenses used to fix up and sell company owned real estate could hurt the profit from the sale.