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Why 'buy and hold' isn't all it's cracked up to be

There are many investors who have never known anything else except for "buy and hold" but it's important to remember just how powerful proactive strategies can be.

The traditional approach imposed by big brokerage firms has always been to buy and hold, even when the market is at very lofty levels. During my tenure at some of these big houses (prior to founding Stock Traders Daily in 2000), I found serious flaws in that approach. One of the flaws became obvious as the Internet bubble burst. If the market is irrationally exuberant, why shouldn't investors go to cash?

Traders on the floor of the New York Stock Exchange.
Getty Images
Traders on the floor of the New York Stock Exchange.

The reason, at least as far as those big name brokerage firms are concerned, is that if you go to cash they no longer earn fees on your money. The brokerage industry is almost all fee-based now, but that often depends on your being invested in something. If you are not invested you do not generate fees for the firm, so the traditional approach of buy and hold is rooted in a practice that is largely rewarding to the business models of those firms.

(Read more: Will tech stocks swoon in 2014?)

Thankfully they are right, and over long periods of time the market will increase. The question is: Do you have that much time? Using the drop from the 2000 peak as an example, most people who were buy-and-hold investors, and who were fully invested in 2000, only became whole again in 2013. In this real-world example, it took about 13 years to recoup your losses. If you were invested in the Nasdaq, you are still underwater, but let's assume that most buy-and-hold investors have recovered, and after this stellar year they are making a little money again.

We also know that the market came close to break-even again in 2007, so because that is a shorter duration and easier for us all to wrap our heads around, we will use that 2007 peak in this evaluation of the power of proactive strategies. A proactive strategy is one that manages risk, one that can work when the market increases or when it falls, but during years like 2013, proactive strategies are often forgotten. Who needs to manage risk when the market moves straight up?

(Read more: Cramer: Your best plays for 2014)

More importantly, why bother to do the extra work, and that's especially an issue for people who think the market will never fall again. We cannot tell if the market will fall hard again but one thing is for sure: If the market falls, buy-and-hold investors will incur another setback, and if the 2013 gains are erased those buy-and-hold investors will essentially still be flat from 2000. In my opinion, there is a better way.

At least with a portion of money, investors should consider a proactive strategy that can work in both directions. An easy example is our Stock of the Week Strategy, which is about buying an individual stock that looks promising. Specific rules are set in place, such as buy at 100, target 105, stop at 99. By rule, every week ends in cash — because it refreshes the brain and allows you to start the next week objectively.

(Read more: Five things that could go wrong in 2014)

This strategy has beaten the market handily since December 2007, but the strategy only did 7.2 percent in 2013, while the S&P 500 gained nearly 30 percent. It was not up as much as the market during this one-sided year, so it, like other proactive strategies, is largely overlooked, but the comparison over time is unquestionable.

The Stock of the Week Strategy has more than tripled the value of the investment since Dec. 2007, while the S&P 500 is up only 23.4 percent over that same period. I am not discounting the S&P's return this year, but if you have been holding since 2007, or 2000 for that matter, virtually all of the gains you have came this year.

The past four Stock of the Week stocks were Starbucks, Moody's, Capital One and United Technologies.

During years like 2013, when the market seems to have no headwinds at all, those types of strategies don't seem to be attractive, but over time proactive strategies can make a significant difference to performance. Every portfolio should have some money in a proactive strategy.

— By Thomas H. Kee, Jr.

Thomas H. Kee, Jr. is president and CEO of Stock Traders Daily and founder of The Investment Rate. Follow him on Twitter @marketcycles.

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