Is Buy-and-Hold a Viable Strategy?

By | December 22, 2014

Is Buy-and-Hold a Viable Strategy?
Yes . . . and Still the Best One.

Rob Pivnick, Author of “What All Kids (and adults too) Should Know About . . . Saving & Investing
Twitter @RPivnick         www.whatallkids.com

Is buy-and-hold as an investment strategy dead? The answer to that question is the same as the answer to each of the following questions:

1) Can you successfully time the market?

2) Should you chase returns?

3) Is the average investor smarter than the professionals with all those resources at their fingertips?

No, no, no and no. Buy-and-hold, however, as the best investment strategy assumes a long term investment horizon – like ten or even twenty years. Even Warren Buffett says his “favorite holding period is forever.” In fact, if you look at market returns going all the way back to the late 1800’s, you’ll find that the average rolling 10-year return from any given month is about 9% a year.

Curiously, though, folks who proclaim buy-and-hold dead use volatility measured in much shorter periods, like months, weeks or days as a reason that it doesn’t work. It is true that buy-and-hold will not outperform every day, week, month or even year – look at any down period as proof of this. You might find yourself thinking that you can create alpha and generate better returns by pursuing anything other than a buy-and-hold strategy. Don’t fall into this trap . . . because at the end of the day (or decade, in the case of long term investors), a buy-and-hold strategy will increase returns and reduce risk.

Buy-and-hold requires commitment to a long term horizon. Investors can not try it out for a quarter or two, or a year here and there – if you “try” it for a short period, you might end up also proclaiming it as a strategy of the past. A strategy for losers. If you find yourself asking how buy-and-hold has done year to date, the strategy isn’t for you. Those that want to proclaim buy-and-hold dead are those without the patience to follow it. As John Madden said, “the road to easy street goes through the sewer.”

REVERSION TO MEAN AND THE EFFICIENT MARKET

The market always reverts to its mean (by definition) – in fact, this is Rule #1 of Jack Bogle’s ten rules of investing. I’m a believer in some sort of weak version of the efficient market hypothesis (EMH). The EMH is the idea that one can’t consistently beat the market without increasing risk – it states that the market itself is efficient and its performance is based on all the information about stocks that is available.

Admittedly, there are certain anomalies that might allow for opportunities to beat the market over the short term (only). For example, investors/hedge funds with access to master limited partnerships and other alternative investments in smaller markets may be better positioned to actively manage their investments. Among many reasons, a) these investments are less liquid than the broad equity markets, b) these smaller markets generally keep out larger players who could move the market, c) these funds are run by uber-experienced managers in their space and d) such markets are heavily retail – that is, they are held by folks who tend to make rash decisions at precisely the wrong time (i.e., you – more on this below). In illiquid markets like this, these factors exacerbate price movements and may provide opportunities not seen in the broader general markets – making them inefficient by definition.

But we would be wise to leave those strategies to the professionals with high powered computers (that you don’t have) using proprietary algorithms (that are not available to you) that process research (to which you don’t have access). Even with these advantages, however, only 20-35% of professionally managed funds beat the market over the last five years.

That’s right, even the professionals can’t beat the market. Neither can you.

So let’s assume that over the long term the broad based markets are at least quasi-efficient. Maybe there is some room to create alpha and some areas where real, risk-adjusted gains could be achieved. But after taking into account fees, commissions, cost of research, acquiring information, etc. –consider the markets efficient – at least for most people.

Now, toss in the inherent difficulty (impossibility?) in distinguishing between the skill and luck of investors (especially over time horizons that we humans like to) and the propensity for people to buy and sell at the wrong time (for all the behavioral and emotional reasons we all know and love) . . . well, this makes buy-and-hold the right call for 99% of investors.

YOU CAN NOT TIME THE MARKET

In fact, most investors miss out on the good times precisely because they jump in and out of the market at the wrong moment. They think they can time the market. They make investment decisions based on emotions. In the 20-year period ended in 2013, stock investors earned only 5.0% a year due to terrible market timing, nearly 4 percentage points less than a buy-and-hold strategy. Why? Because we are terrible at investing. We chase returns. We react to fear. We buy into the media hype. And we invest emotionally.

Emotional investing causes most of us to buy high and sell low. In fact, the year 2000 saw a historical record inflow into domestic equity funds. Immediately following that the market dropped almost 50% (fueled by the dot.com bubble bursting). In 2008, the opposite occurred as a record was set for the most outflows of funds from domestic equity funds. What happened next? The market has been on an unprecedented climb since then, with returns reaching almost 200% from the market low. As of the date of this article, it’s still climbing. And most investors missed out on that recovery.

But . . . what if you could avoid the bad days . . . ? If you thought you could time the market and miss all the bad days, you’d be in great shape. But if you get out of the market at the wrong times, you also end up missing out on big rallies. If you missed out on just the 10 best days in the 20-year period ended 2013, your average annual return would have dropped to 5.5%. Miss the 30 best days and your return is 0.9%.

The naysayers might point out that starting in 1990, the market has reverted to within 1% of its opening value at least once in every given year. If that’s the case, investors would have killed it by getting in at the low, then selling at the high. Rinse. Repeat. Seems simple enough. Ahhh, if only we could invest looking in our rear view mirror. If you think you can successfully implement this market timing strategy, go back up a few paragraphs and re-read.

DO NOT CHASE RETURNS – STAY DIVERSIFIED

A passive investment style means that as an investor you do not chase returns. You should not expect that an investments’ past performance from last year will continue the next year. In fact, most stocks and funds that beat the market in the past generally will not do so in the future. Good past performance is often a matter of luck. This is why active investors who constantly chase returns get burned. Why? Because past performance is not an indication of future performance.

Here is a fun fact for you: n the fifteen years prior to 2011, 46% of actively managed funds closed because their performance was so bad. During that same period, 7% of funds failed every year for the same reason. And these funds were run by professionals! You still think you can beat the market?

Go online and pull up any periodic table of investment returns and you’ll get a great visual of how a diversified portfolio beats trying to pick sectors over the long term. Plus, most of them are really colorful and pretty.  But believe it or not . . . studies have shown that past returns remains the primary investment decision most investors consider when choosing among investments!

MINIMIZE COSTS/EXPENSES

Actively managed funds have an average expense ratio of 1.25%; passively managed funds have an average expense ratio of 0.25% expenses. One percent may not sound like much, but when you strip one percent off of the historical average of around 8.5-9%, then it becomes much more meaningful because it equates to almost 12%. So if you go the active route, you are losing almost 12% of your annual return. How does this translate into dollars . . .? Well, if you invested $100,000 over thirty years at an average return of 8.5%, paying for those higher expenses/fees would cost you approximately $280,000 (~$1,072,000 passive versus ~$792,000 active).

So if all investments (active v. passive) ultimately produce the same average returns over the long term (i.e., they all revert to their mean), why would you pay much more for the actively managed funds? Indexing/passive investing will make you more money because it provides the same returns as active investing at a much, much lower cost.

Another fun fact: in just about every Morningstar category for the ten years recently ended, low cost funds outperformed the high cost funds. You know that past performance is no indication of future returns. What you might not know, however, is that the single most accurate predictor of future returns is low fees. That’s rights . . . studies have shown that focusing on low fees solely would result in better returns for investors. When looking at factors such as past performance, manager tenure, expense ratios and Morningstar ratings – expense ratios were the only reliable predictor of future performance. From Morningstar’s own Director of Fund Research Russel Kinnel: “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds. . . . Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.”

NOTE: STRATEGIC TILTS ARE O.K.

It isn’t necessarily a bad strategy for portfolios to have some allocation in a proactive strategy. Allowing a small portion of one’s portfolio to be used to play strategic tilts certainly makes it less boring and keeps investors engaged. After all, buy-and-hold isn’t the sexiest strategy, but it works. Use a small proportion of your holdings for proactive investing and strategic tilts – it will keep you engaged. But do not actively try to time the markets, chase returns or invest emotionally with the bulk of your portfolio. Take the average 8.5% annual return to the bank over the long term. You’ll be happy you did.

 

ABOUT THE AUTHOR
Rob Pivnick is an investor, entrepreneur, attorney, residential real estate investor and financial literacy advocate. Rob has both a law degree and an M.B.A. from SMU in Dallas, TX. He is a member of the board of directors of the Texas affiliate of the national Council on Economic Education. Professionally, Rob is in-house counsel for Goldman, Sachs and Co. and specializes in finance and real estate.

ABOUT ROB’S SAVING & INVESTING BOOKRob’s book, “What All Kids (and adults too) Should Know About Saving & Investing,” targets young adults/millennials with vocabulary words, fun facts, “Did you know?” sections and 14 key takeaways. Statistics, charts and graphs from expert sources bolster the information. It aims to help students develop proper habits for saving and investing for long term. Not get rich quick. Chapters include budgeting, debt, setting goals, risk vs. reward, active v. passive strategies, diversification and more. Visit www.whatallkids.com for more information. Twitter: @RPivnick.

 

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