A legitimate concern with a buy and hold investing strategy is that it may underperform active management during fluctuating and bear markets.
True. But as we have seen in prior posts, the ability of active managers to correctly time market movements is questionable. So, yes, in a perfect world, active would be preferable. But in the real world, the added costs of active management and the inability to time market shifts does not tend to create alpha (i.e., outperformance by managers).
Today we will review how to protect your wealth during periods of market volatility when using buy and hold.
Long Time Horizon
One’s overall investment horizon should be relatively long-term. Of course, within that longer time horizon for retirement, there will be a few short and medium term financial objectives. But the bulk of your focus will be long term.
As stated above, in a perfect world active management may perform better than passive in volatile markets. I say “may” because who knows. Would you have bought and sold at the right times? Or would you have compounded your losses through even worse timed trading?
As we saw last week, the “experts” overwhelmingly got the Trump election economic impact wrong. In the last 5 years, you can also look at the general consensus that inflation and interest rates would increase significantly. Nope. Had you shortened fixed income duration based on this consensus, you would be worse off.
The BREXIT on June 23, 2016 was another tale of doom and gloom. The pound fell to 1.29 USD and “some commentators have warned sterling could yet slump to parity with the dollar.” Instead, the pound currently trades at 1.25 USD. Or post-BREXIT vote, the pound traded at 1.17 Euro. Today the pound trades at 1.11 Euro. And yes, in the pre-vote optimism to remain, the pound rose to 1.45 Euro. A big crash. But if you ignore the run-up to the vote in mid-2016, you will see the historic trading range for the 5 years before the vote was pretty much in a 1.15 to 1.25 trading band. Further, consider the FTSE 100 stock market index. It traded at 6338 on June 23, 2016. Currently, it trades at 7537. Not as impressive a growth rate as the U.S. stock markets, but a decent gain of 18.9% over the period (not factoring in any dividend distributions to investors). So while not wonderful, not the apocalyptic aftermath predicted by many “experts” (as they tried to scare voters into staying).
In these two examples, the “experts” got it very wrong. Had you traded based on their advice, you would be much worse off than simply staying the course. Will they get it right next time? Perhaps. Perhaps not.
But over the long term, appreciating assets have appreciated in value. Should you pay a healthy fee to jump in and out? Especially if the advice is poor?
Asset Allocation
Now some of you reading this are thinking, “Hey, I don’t have 20 or 30 years to invest. What can I do?”
If you recall our discussions on investor profiles and investment policy statements, you realize that your asset allocation is geared, in part, to the phase in your life cycle.
Over the course of your life cycle and ever evolving investor profile, the amounts that you allocate to cash, fixed income, and common shares will change. As you near retirement, you will be shifting more of your wealth into lower risk (i.e., less volatile) assets. For example, we saw how one’s allocation to equities changes based on the life cycle phase.
This will also address problems with general market volatility.
When young, with a long time horizon, you can handle more volatile assets in your portfolio. As your risk tolerance (and ability to withstand volatility) decreases through your life cycle, you shift into a higher percentage of lower risk asset classes. As your financial time horizon nears, portfolio risk (and impact of market volatility) lessens.
Diversified Portfolios
I have previously discussed investing in diversified portfolios.
A diversified portfolio prevents you from having all your eggs in one basket. Whether that be a specific asset within a market or an individual market within the whole spectrum of investment options.
If you have 50% of your wealth in shares of Credit Suisse, your portfolio returns will reflect the results from Credit Suisse to a significant degree. Or if you have invested 80% of your assets in the U.S. equity markets, your portfolio will mirror the ups and downs of the U.S. equity markets.
Either of these may generate positive returns during bull markets, but they will create problems during down periods.
However, by diversifying throughout various asset classes, you can spread the risk of any one market throughout multiple asset classes.
Not Just Diversified, But Well-Diversified
A diversified portfolio is a collection of different assets.
A well-diversified portfolio reflects a proper mix of assets, such that you minimize asset correlations.
If you recall our discussions on asset correlations, holding assets with low or negative correlations will provide some built in protection against market volatility. As the value of one asset rises, the value of a negatively correlated asset should decline.
While you may give up some potential return by never being fully invested in rising markets, you will also never be fully exposed to falling markets.
This offers a defence against market downturns.
Dollar Cost Averaging
Another strategy I have espoused is dollar cost averaging (DCA).
I think this also provides some protection against market volatility.
If you believe over the long run that appreciating assets do, in fact, appreciate, then down markets provide buying opportunities.
We have covered the above points previously in significant detail. I reiterate them to show how we have already take steps to protect our portfolios from legitimate potential problems with employing a buy and hold strategy.
Nest time, we will look at tactics we have not previously discussed.
