The abruptness and severity of a liquidity crisis tests the emotional and financial reserves of investors

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BUY-AND-HOLD investing isn't for the faint of heart. It works only if you're willing to hang onto losing stocks for very long periods, in downturns that may be far sharper than you ever imagined. If you don't have such fortitude, you're better off selling at the first sign of trouble and sitting on the sidelines.

Those, at least, are the implications of one of the first academic explorations of the recent liquidity crisis, When Everyone Runs for the Exit, by Lasse H Pedersen, a professor of finance at New York University. The study began circulating this summer in academic circles.

In a liquidity crisis, as we have seen all too recently, a sudden tightening of credit sets off a vicious cycle of margin calls that lead to forced sales, which in turn cause asset prices to plunge, and so on. Invariably, the abruptness and severity of the crisis test the emotional and financial reserves of investors.

In an interview, Pedersen used a poker analogy to summarise which groups of investors perform the best and worst in these crises. The 'strong hands' have what it takes to survive, he said. Not only are they emotionally strong enough to avoid selling into a panic, but they also have deep-enough pockets to avoid doing so for financial reasons. In fact, the 'strong hands' can actually profit by buying at cheap prices near the bottom of a market.

By contrast, the 'weak hands' never harboured any illusions about being able to hold on. They 'fold immediately and therefore suffer limited losses', Pedersen said. Momentum investors, for example, fall into this category, he said, because they constantly shift their portfolios away from securities that have lost the most money.

(And momentum investors can sometimes turn a profit during a severe crisis because, midway through it, they may have 'shifted their portfolio to profit from the crisis continuing', he said.) The professor refers to the investors between these extremes as the 'strongest weak hands'. They end up losing the most money. These investors 'initially think they have a strong hand', he said, and hold on for a while as their losses become more severe. Eventually, they discover that they aren't as strong as they initially thought - emotionally, financially or both. They 'are forced to sell at or near the bottom'.

These findings may be particularly unsettling for some converts to buy-and-hold investing from '02 to '07, who held onto their positions for months as stocks became toxic in 2008, only to sell at a loss deep into the debacle. Pedersen says these people probably would have lost much less had they never tried to become buy-and- hold investors and instead remained short-term traders.

Their outsize losses aren't the fault of the buy-and- hold approach, the professor says. Instead, the problem is that they failed to appreciate how much patience and fortitude are needed to tolerate a liquidity crisis. Trying and failing leads to greater losses than not trying at all.

He added that, based on news reports, he suspects that some foundations and college endowments also found themselves in the 'strongest weak hands' category. One might have thought that such institutional investors would be the ultimate 'strong hands', because their endowments were set up to support them in perpetuity.

Their apparent Achilles' heel, Pedersen said, was to have 'tied their operating budgets so closely to endowment income', forcing them to 'sell some of their holdings at fire-sale prices'. So soon after the gargantuan losses of 2008, of course, it's not certain that buying and holding will continue to be a viable long-term strategy. It may take many years to know. But Pedersen says it is already clear, for strategic reasons, that it's better to hold securities for a very long time or to sell rapidly when conditions worsen - but not to equivocate. -- NYT