Why not "time-tested" Buy-and-Hold?
There are 4 reasons why we believe Buy-and-Hold as an investment strategy for retirement is actually harmful for your portfolio, and that the right tactical Absolute Return strategies need to be a key part of your mainstream investment solution.
- Buy and Hold has rarely worked historically
- Buy and Hold is a matter of luck
- Buy and Hold is not worth the risk or the heart-ache
- Theories underlying Buy and Hold are full of holes
Given the extraordinary misinformation distributed by the financial industry on the subject, we strongly recommend your reading through these points or calling us.
We all know that investing in the stock market has not exactly been a winning proposition since 2000 where real dividend re-invested return (adjusted for inflation) for the S&P500 has been -3.4% annualized (thru the end of 2009) or a total real decrease in the purchasing power of a hypothetical portfolio invested in the S&P500 of 29%. But even if we assume a longer-term investment horizon, the story from the last 140 years is not pretty as shown in Figure 1 below which charts the 30 year annualized returns for the inflation-adjusted dividend-reinvested S&P Composite index which does not account for any investment fees. Only in 27% of the last 120 years did the long-term real-returns from US equities go over 5%.
Traditional investment strategies and conventional wisdom promoted by Wall Street and embraced by most of the financial establishment (including possibly your very own financial adviser or planner) have ignoredthis reality and have foisted the idea upon us that 10% pre-inflation returns are obtainable from the stock market in the “long-term”, no matter what environment we begin investing in if we simply 1) Invest in a diversified portfolio of equities, bonds, commodities, real estate, etc. and 2) Hold-on through thick and thin for the long-haul with the quarterly or annual rebalancing. Let us test this idea using the above chart. The long-term rate of inflation which “everyone” knows is 4%, which means the claimed long-term real rate of return available from US equities is 6% if one re-invests dividends, right?
The red-dashed line in the chart above is drawn at the 6% level. The 30 year real annualized dividend reinvested returns for the S&P Composite index rise above 6% in only 14% of the 120 years from 1901 to 2010. We are coming off brief 13 year period in which long-term investors have succeeded in garnering a >6% return but that is the exception rather than the norm historically. In fact, the average 30 Year US Equity market real dividend-reinvested returns for investors who retired between 1901 and 2010 was 3.6% on an annualized basis.
Buy and Hold is a Matter of Luck
Markets are cyclical and have historically alternated between secular (long-term) bull and bear markets as is shown in Figure 2 below. Actually secular bear markets have lasted for at least 15 years (to 19 years) whereas the two secular bull markets in the early 20th century were 9 years long and the two since 1948 have been 18 years long each. Since 1880, Secular Bull markets have roughly been in force 41% of the time while Secular Bear markets have been in force for 59% of the time. Stocks have grown (in real terms) at a 12.8% annual rate during the secular bull markets since 1900 but have lost investors -3% annually (in real terms) in the secular bear markets in the same period. Average real loss during any of these secular bear markets over the 15 to 19 year period was 42%.
Figure 3 below dramatically illustrates the cyclical nature of the long-term returns available from buying and holding the market. We will somewhat arbitrarily call a long-term real return above 4% as being “good” and below 4% as being “poor”. The green shaded regions are the “good” years to retire in and the red shaded regions are the “poor” years to retire in. These green and red shaded areas correspond to secular bull and bear markets respectively shown in Figure 2 (except being shifted forward by a few years as one would expect since we are looking back 10 yr to 30 yr to calculate returns). So whether a long-term investor’s net return, after adjusting for inflation, was positive or negative, was mostly a matter of when he started and when he stopped investing, i.e. whether he was born at the right time and/or retired at the right timeor even made his investable money at the right times. Most people today are rapidly falling into the “unlucky” category. If these cycles continue to hold, we should see a further deterioration in long-term returns in the 2nd decade of the 21st century as the cyclical pattern indicates. Looks like a bad decade or more to retire in for committed Buy-and-Holders, which a significant part of the population will be.
Buy-and-Hold is not worth the risk or the heartache
Buy-and-Hold as a strategy has no risk management built into it. You buy, and then you hope for the best. If the markets start dropping, you keep holding, hoping that the market will eventually recover, hopefully sooner rather than later. In fact you are encouraged by your Financial Advisor, if you have one, to keep holding no matter what the draw-down (a technical term for the peak-to-trough drop in the value of your portfolio). Using the same Real Dividend reinvested S&P Composite data we have been using, Figure 4shows the Drawdown reached subsequent to each preceding portfolio peak. This is the “heartache” or “lurching stomach” factor which your financial advisors may not have prepared you adequately for when they try to sell you their services. Are you prepared to grit your way through a 50% drawdown that the markets deal you with? What if you plan to retire in 10 years … or 5?
Another way to look at this is to compare a Buy-and-Hold strategy with other investments or strategies in terms of the risk-to-reward. Figure 1 (shown again below) in the light red shaded area shows the risk-spread for investing in equities, i.e. the amount of excess 30-Year real return available from investing in the US stock market compared to the 30 Year real return from holding the 1-Year T-Bills. The average 30 Year Real return for our Long-term stock market investor for the last 110 years has been 3.6%, only 1.62% higher than the 30 Year Real return for our Long-term 1 Year T-Bill investor. Our stock market investor had to risk about 2 dollars for each dollar of gain, to get a 1.62% higher yield than the almost no-risk T-Bills. And our hypothetical retirees obtained a risk-spread > 4% for investing in equities relative to the 1-Year T-Bill in only 14% of the years since 1901. Is the possible gain worth the pain?
Theories underlying Buy-and-Hold are full of holes
Buy-and-Hold and the idea of building a diversified and static portfolio using domestic and global stocks and bonds according to one’s risk tolerance or investment goals, is built on the foundation of the Efficient Market Hypothesis (EMH), Modern Portfolio Theory (MPT), and the idea that markets follow a “Random Walk” rather than exhibiting any systematic structure. EMH is the idea that security prices are rationally determined, reflect all available information, and seek equilibrium. MPT, which resulted in a shared Nobel Prize in 1990 for its founder Harry Markowitz, puts forward the concept of diversification and the thesis that a portfolio can be constructed on the “Efficient Frontier” that optimally balances risk and reward from an “uncorrelated” selection of investments. The random walk hypothesis is a financial theory stating that stock market prices evolve according to a random walk per the bell curve or Gaussian distribution and thus the prices of the stock market cannot be predicted.
Some significant facts that fly against these hypotheses are
Warren Buffett and successful market timers who have gotten lucky for a very long time (if these hypotheses are true)
Structure that exists in the markets in terms of clear trends and repeatable patterns which manifests themselves as fat tails in price statistics where EMH expects normal Gaussian distributions
Large discrepancies between price and fundamental valuation of assets seen frequently over large time periods or during bear markets like 2008, and
A correlation in global markets and asset classes seen most strongly since 2008 where most asset classes (stocks, bonds, commodities, real estate, etc.), have generallydropped and then risen together, some more than others.
Until recently, theorists lacked exposure to a persistent, years long downtrend, so the belief in the Efficient Market Hypothesis (EMH) and the impossibility of a fully diversified crash persisted. According to this hypothesis, investors cannot consistently beat the markets because markets move in a random fashion and adjust instantly and rationally to the news. The only path to higher returns is to bear greater risk, however the theory goes on to propose that the risk can be reduced by remaining fully diversified at all times. Modern Portfolio Theory (MPT), builds off these tenets to propose an “efficient frontier” where risk is supposedly minimized and return maximized. Counterarguments began surfacing in the media after the 2008/2009 market beating. A Feb 14th, 2009 headline from Barron’s proclaimed “Modern Portfolio Theory Ages Badly: The death of Buy and Hold”. People are questioning the standard 50 year definition of “long-term” and calling for 100-300 years of data which provides a better perspective to understand the decline in 2009 and the subsequent market rally. Research that contradicts these modern financial theories from the budding field of Behavioral Finance and from top universities has also been emerging. Prechter and Wagner compile this research in a June 2007 paper published in the Journal of Behavioral Finance titled “The Financial/Economic Dichotomy in Social Behavioral Dynamics – The Socionomic Perspective”, in which they also propose an entirely new model based on the new concept of Socionomics to better explain the workings of financial markets.
The most commonly held out explanation for these times by EMH practitioners is that 2008 was a “black swan” event, i.e. something that happens very rarely, and that things will happily get back on the “random walk” track and efficient markets will return for the long haul … so please go on buy-and-hold’ing through this discontinuity, and in fact buy some more if you will, thank you. The scientific method would state that the exceptions render the entire theory untrustworthy, especially since there is no way to objectively determine when the theory would work and when it would not. Benoit Mandelbrot, the late Professor Emeritus of Mathematics at Yale and the author of The Fractal Geometry of Nature and The (Mis)behavior of Markets wrote in a 2006 Financial Times article that “The problem is that measures of uncertainty using the bell curve simply disregard the possibility of sharp jumps or discontinuities and, therefore, have no meaning or consequence. Using them is like focusing on the grass and missing out on the (gigantic) trees. In fact, while the occasional and unpredictable large deviations are rare, they cannot be dismissed as “outliers” because, cumulatively, their impact in the long term is so dramatic … One can safely disregard the odds of running into someone several miles tall, or someone who weighs several million kilogrammes, but similar excessive observations can never be ruled out in other areas of life …Despite the shortcomings of the bell curve, reliance on it is accelerating, and widening the gap between reality and standard tools of measurement. The consensus seems to be that any number is better than no number – even if it is wrong. Finance academia is too entrenched in the paradigm to stop calling it ‘an acceptable approximation’.”
Clearly, there is a massive disconnect between market behavior and economic reality and the rational behavior of investors. The pillars of modern financial theory may actually have been made of sand rather than stone. Do you want to build your financial house on these?
Progress was unleashed on the world after Kepler and Copernicus rang the death knell of the “Flat Earth” hypothesis in the 1500’s. Our goal at THE ABSOLUTE RETURN is to do the same with your portfolios based on theories that better align with market price and economic history, and which use tactical investment strategies and sophisticated risk management that seeks to preserve your capital, expose your portfolios to less risk for higher potential returns, and provide absolute returns independent of market direction.
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