Buy-and-Hold: Mission Impossible?

 

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Marketwatch’s Chuck Jaffe recently wrote an interesting article challenging the practicality of the decades-old investment approach known as buy-and-hold, citing a “leading money manager and behavioral finance expert” as claiming that the approach is impossible. The two folks that Jaffe quotes in the article claim that the impact of seeing investments go down dramatically (as happened in 2008-09) is just too much of a challenge to someone’s emotional discipline for them to maintain their investment positions.

The basic idea of a buy-and-hold approach is straightforward: pick your investments and stay with them, through thick and thin. That could be contrasted with an approach that might involve more trading in and out of investments in anticipation of market ups and downs.

The evidence indicates that, on average, a comparison between the two approaches isn’t even close. If you had decided on January 1st, 1994 to put $10,000 into the S&P 500 Index (a broad barometer of large US company stocks) and then just forget about it for 20 years, your investment would have grown to over $58,000 by December 31st, 2013. That’s an annualized return of 9.22%.

While it’s impossible to evaluate every trading strategy that’s out there, we can at least compare that buy-and-hold return against the return obtained by the average stock fund investor over the same period. According to research company DALBAR, the average equity fund investor saw an annualized return of just 5.02% in the 20 year period ending in 2013, representing a 4.2% annualized gap.

We can’t tell from the data what exactly causes the performance gap, though we might suspect that it’s some combination of overconfidence, performance chasing, overtrading, and overreacting to recent events. Case in point: to get the buy-and-hold return, you would have had to cope with or outright ignore the gut-wrenching periods of 2000-2002 and 2008-2009, when the S&P 500 index lost about 50% of its value. That’s a tough ride, and a lot of people just didn’t make it. Unfortunately, most people find out they don’t quite have the stomach for something like that until it’s too late, when they sell after the worst has already happened. And maybe that’s the reason that leads some to think that a buy-and-hold approach is “impossible.”

Unfortunately, neither expert in Jaffe’s article provides a better alternative. The temptation is to use a an active trading strategy that attempts to sell before the market drops and then buy back in before it goes back up. When someone is able to consistently do that, it will be the first time.

Of course, these two approaches (active trading/market timing vs. buy-and-hold) are at the extreme ends of the spectrum. “Buy-and-hold” doesn’t necessarily mean “buy-and-ignore.” And in reality, very few people who describe themselves as buy-and-hold-types invest their money one time and then never change anything.

Instead, they might take the approach favored by Woodward Financial Advisors and start by deciding on an appropriate mix of more and less volatile assets, in order to dampen the big market swings that incite people to sell out at the worst possible time. From there, they would identify broadly diversified mutual funds to gain exposure to a variety of different types of stocks, bonds and other asset classes. Over time, that mix would get tweaked, as new asset classes are added, funds are reevaluated, or small changes are made to how much weight to give a particular asset class. And finally – and perhaps most importantly – the entire portfolio would be regularly rebalanced back to its target after market run-ups, declines, withdrawals and deposits.

In financial advisor jargon-speak, this is called Strategic Asset Allocation. We prefer to think of it as prudent and responsible investing. No matter what you call it, it’s not just picking a couple of funds and calling it a day.

Our mission – should we choose to accept it – is to help our clients close that performance gap by following a sound investment philosophy and approach, and not letting short-term emotions derail a perfectly good plan.

About Ben Birken

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