Buy and Hold: The Rest of the Story
We all make a lot of our investment decisions by creating a pair of alternatives and then choosing between them. Many an argument about investing comes down to this kind of choice too: Either pursue a buy-and-hold strategy, staying fully invested in the market through all of its ups and downs, or else try to time the market, by moving out near predicted tops and back in near bottoms.
Unfortunately, it's easier to make bad decisions than good ones this way. Too often , the alternatives are described inaccurately. And almost inevitably, other viable choices are ignored.
The argument between buy-and-hold and market-timing strategies usually goes astray in just such a way. First, most studies supporting one strategy or the other are fantasies that have little to do with the way either works for real investors. Secondly, thinking only in terms of these two choices blinds investors to a third way, one that deserves your most serious consideration.
The best way to demonstrate why the either/or choice between buy-and-hold and market-timing is so misleading is to look at one of the studies that argues this side or that. According to this study, $5,000 invested in the S&P 500 Index at the stock market's peak each year for the past 20 years would be worth more than $465,000 at the end of that 20 year period... NOTE: A market peak is the worst time to buy, and yet, Buy and Hold, the study says, works!
But what exactly does that study prove? Almost nothing, it turns out. First, the study really says very little about the superiority of either market-timing or buy-and-hold. Instead, it's really an endorsement of dollar-cost-averaging, a proven investment technique that virtually everyone on either side of the market-timing debate endorses. In dollar-cost-averaging, an investor sets aside the same amount of money every month or every year and ignores market gyrations. In the case of a new investor building a market portfolio, it can be an excellent strategy -- provided that investor has many years to wait before needing his or her money.
Second, the study doesn't accurately describe the two alternatives. The period of the study - the past 20 years - is itself a sort of distortion. It's common knowledge that the past decade hasn't been representative of the long-term profits available from the stock market. True, the period 1995 to first quarter 2000 produced returns that were incredible, however, since that time we have been in a secular bear market in which we are presently enjoying a cyclical bull period which some market pundits are predicting may end within the next thirty days!
The timing of those market peaks and downturns is just as important as is their frequency. Suppose that study had begun in 1955 and run for 20 years, so that the period ended with the steep 1973-74 bear market decline. The outcome would be shockingly different. In this case, the investor's total profit would be only 36 percent. Imagine saving and investing regularly for 20 years and ending up with less than you could have earned from a savings account yielding 3 percent.
Buy and hold does make sense for the new investor. But the closer an investor is to retirement or to needing his or her investment capital, the more dangerous a buy-and-hold strategy becomes. The numbers are very clear.
A student of bear markets can point to other flaws in buy-and-hold studies. For example, most buy-and-hold arguments and historical studies use blue-chip averages like the Standard & Poor's S&P 500 Index and the Dow Jones Industrial Average in calculating bear market risks and losses. Both are large-company indexes that ride through market downturns very differently from small company indexes, like the NASDAQ or the Value-Line Indexes.
Of course, it's one thing to point out the problems in these pro buy-and-hold studies and quite another to prove that market timing is a superior, or even valid strategy - especially when most studies in favor of market-timing are seriously flawed in their own way. To prove that market-timing works, these studies often assume an ability to get in and out of the market at bottoms and tops. Market timing of this sort is virtually impossible.
But consider a third alternative. Most healthy bull markets share certain characteristics. These include declining or stable interest rates, broad participation and strong leadership among stocks, and an identifiable uptrend in market indexes. The more characteristics like these you can identify, the more aggressive an investment strategy you should employ. The fewer you see, the more cautious a course you should steer.
Merely knowing that the Federal Reserve had started to raise interest rates should have been strong confirmation that the first half of 2005 would not be good to investors. When indicators like this one start pointing to danger, prudent investors move to reduce the risk of bear market losses by shifting some of their portfolio out of the markets.
Most investors who use portfolio allocation only shift their assets between stocks and bonds, staying totally invested at all times. But that doesn't reduce risk when bonds fall at the same time as stocks. And as we saw in the inflationary decade of the 1970s, bonds can tumble even further than stocks.
There is a better option, one that treats cash (90-day T-bills or Treasury money market funds) as a viable investment alternative at specific times.
To avoid overestimating an investor's ability to know when to make a move, let's pick a very simple rule as a guide. We'll use a moving average to gauge the market's long-term trend. For example, a 150-day moving average of the S&P 500. We can calculate that average by taking the closing prices of the S&P 500 Index on each of the last 150 trading days, and averaging them. Then, we use this indicator to read the market. If today's close of the S&P 500 Index is greater than that average number, then we can conclude that the market is in an uptrend. If instead today's S&P Index is less than the moving average, the market is in a downtrend.
Now suppose we buy a mutual fund approximating the S&P 500 Index when the index is trading above the 150-day moving average. Suppose also that whenever the S&P 500 Index falls below the 150-day moving average, we then shift our portfolio into the safety of T-bills or a treasury money market fund.
Over the past 40 years, such a strategy could have more than doubled an investor's total return from the stock market - as compared with a buy-and-hold strategy for the same time period. These results come from risk management, and not from picking tops and bottoms.
The individual using the 150-day moving average to determine when to sit quietly on the sidelines in cash wouldn't have avoided all down markets, but the worst-case loss would have been a 15 percent loss. This strategy would have avoided every one of the major losses during this period, however, even though it never caught the exact top or bottom of the market. It merely introduced sensible risk management to any portfolio that followed this strategy.
There are alternatives to a blind buy-and-hold strategy. The wise investor knows that the best strategies don't just seek the highest possible return - but the highest return with the lowest risk!
* * * * *
Unfortunately, it's easier to make bad decisions than good ones this way. Too often , the alternatives are described inaccurately. And almost inevitably, other viable choices are ignored.
The argument between buy-and-hold and market-timing strategies usually goes astray in just such a way. First, most studies supporting one strategy or the other are fantasies that have little to do with the way either works for real investors. Secondly, thinking only in terms of these two choices blinds investors to a third way, one that deserves your most serious consideration.
The best way to demonstrate why the either/or choice between buy-and-hold and market-timing is so misleading is to look at one of the studies that argues this side or that. According to this study, $5,000 invested in the S&P 500 Index at the stock market's peak each year for the past 20 years would be worth more than $465,000 at the end of that 20 year period... NOTE: A market peak is the worst time to buy, and yet, Buy and Hold, the study says, works!
But what exactly does that study prove? Almost nothing, it turns out. First, the study really says very little about the superiority of either market-timing or buy-and-hold. Instead, it's really an endorsement of dollar-cost-averaging, a proven investment technique that virtually everyone on either side of the market-timing debate endorses. In dollar-cost-averaging, an investor sets aside the same amount of money every month or every year and ignores market gyrations. In the case of a new investor building a market portfolio, it can be an excellent strategy -- provided that investor has many years to wait before needing his or her money.
Second, the study doesn't accurately describe the two alternatives. The period of the study - the past 20 years - is itself a sort of distortion. It's common knowledge that the past decade hasn't been representative of the long-term profits available from the stock market. True, the period 1995 to first quarter 2000 produced returns that were incredible, however, since that time we have been in a secular bear market in which we are presently enjoying a cyclical bull period which some market pundits are predicting may end within the next thirty days!
The timing of those market peaks and downturns is just as important as is their frequency. Suppose that study had begun in 1955 and run for 20 years, so that the period ended with the steep 1973-74 bear market decline. The outcome would be shockingly different. In this case, the investor's total profit would be only 36 percent. Imagine saving and investing regularly for 20 years and ending up with less than you could have earned from a savings account yielding 3 percent.
Buy and hold does make sense for the new investor. But the closer an investor is to retirement or to needing his or her investment capital, the more dangerous a buy-and-hold strategy becomes. The numbers are very clear.
A student of bear markets can point to other flaws in buy-and-hold studies. For example, most buy-and-hold arguments and historical studies use blue-chip averages like the Standard & Poor's S&P 500 Index and the Dow Jones Industrial Average in calculating bear market risks and losses. Both are large-company indexes that ride through market downturns very differently from small company indexes, like the NASDAQ or the Value-Line Indexes.
Of course, it's one thing to point out the problems in these pro buy-and-hold studies and quite another to prove that market timing is a superior, or even valid strategy - especially when most studies in favor of market-timing are seriously flawed in their own way. To prove that market-timing works, these studies often assume an ability to get in and out of the market at bottoms and tops. Market timing of this sort is virtually impossible.
But consider a third alternative. Most healthy bull markets share certain characteristics. These include declining or stable interest rates, broad participation and strong leadership among stocks, and an identifiable uptrend in market indexes. The more characteristics like these you can identify, the more aggressive an investment strategy you should employ. The fewer you see, the more cautious a course you should steer.
Merely knowing that the Federal Reserve had started to raise interest rates should have been strong confirmation that the first half of 2005 would not be good to investors. When indicators like this one start pointing to danger, prudent investors move to reduce the risk of bear market losses by shifting some of their portfolio out of the markets.
Most investors who use portfolio allocation only shift their assets between stocks and bonds, staying totally invested at all times. But that doesn't reduce risk when bonds fall at the same time as stocks. And as we saw in the inflationary decade of the 1970s, bonds can tumble even further than stocks.
There is a better option, one that treats cash (90-day T-bills or Treasury money market funds) as a viable investment alternative at specific times.
To avoid overestimating an investor's ability to know when to make a move, let's pick a very simple rule as a guide. We'll use a moving average to gauge the market's long-term trend. For example, a 150-day moving average of the S&P 500. We can calculate that average by taking the closing prices of the S&P 500 Index on each of the last 150 trading days, and averaging them. Then, we use this indicator to read the market. If today's close of the S&P 500 Index is greater than that average number, then we can conclude that the market is in an uptrend. If instead today's S&P Index is less than the moving average, the market is in a downtrend.
Now suppose we buy a mutual fund approximating the S&P 500 Index when the index is trading above the 150-day moving average. Suppose also that whenever the S&P 500 Index falls below the 150-day moving average, we then shift our portfolio into the safety of T-bills or a treasury money market fund.
Over the past 40 years, such a strategy could have more than doubled an investor's total return from the stock market - as compared with a buy-and-hold strategy for the same time period. These results come from risk management, and not from picking tops and bottoms.
The individual using the 150-day moving average to determine when to sit quietly on the sidelines in cash wouldn't have avoided all down markets, but the worst-case loss would have been a 15 percent loss. This strategy would have avoided every one of the major losses during this period, however, even though it never caught the exact top or bottom of the market. It merely introduced sensible risk management to any portfolio that followed this strategy.
There are alternatives to a blind buy-and-hold strategy. The wise investor knows that the best strategies don't just seek the highest possible return - but the highest return with the lowest risk!
* * * * *
posted by Bob Moser at
4:35 PM
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