by WWM | Jul 10, 2019 | Buy & Hold versus Active Trading
Previously, we looked at a few commonly perceived negatives on the buy and hold investment strategy.
Some of the minor complaints.
Today we will review more legitimate concerns.
Buy and Hold May Not Provide Maximum Possible Returns
A buy and hold strategy is essentially as it states; you acquire an asset and hold it throughout the investment horizon.
Investment theory indicates that over time, on average, appreciating assets (such as equities) will increase in value. Granted, it may be a long time, but historically this has held true.
However, over the short and medium periods, there may be large price fluctuations in an asset. The greater an asset’s risk (aka volatility), the greater the potential price swings.
If an investor can properly time the peaks and valleys of short or intermediate price fluctuations, the investor can sell high, then repurchase the same asset when it falls. This ensures the same position at the end of the investment time frame, but by selling and buying back the investor can profit on price fluctuations.
In short, the belief is that active management can outperform passive investing.
I would say that this is a legitimate issue for a buy and hold strategy.
However, I would also say that it is questionable if active can outperform passive over the long term.
Buy and Hold Does Not Protect in Down Markets
Markets, and the assets within a market, go through down cycles. Depending on the length of time, this may be called a crash, market correction, or possibly a bear market.
A buy and hold strategy sees investors sit tight during market descents. With some bear markets, this can wipe out previous accumulated gains and/or create portfolio losses.
Smart investors shift their assets in down markets into defensive positions or alternative asset classes that protect their capital.
Again, active management can protect portfolios during down cycles. However, as linked above, the ability of active managers to correctly time market corrections is (surprisingly) poor.
As a current example, google the amount of experts who predicted U.S. interest rates would significantly rise (over the last 3-5 years). Yet interest rates have remained relatively stable versus predictions. Had you not listened to the “experts” and remained in long duration bonds (as opposed to shortening durations in anticipation of rate hikes), you would have been better off.
Or consider how the “experts” reacted to the 2016 Donald Trump election victory.
“It really does now look like President Donald J. Trump, and markets are plunging. When might we expect them to recover? A first-pass answer is never… So we are very probably looking at a global recession, with no end in sight.” Paul Krugman of the New York Times the day after the election.
“If Trump wins we should expect a big markdown in expected future earnings for a wide range of stocks — and a likely crash in the broader market (if Trump becomes president).” Eric Zitzewitz, former chief economist at the IMF, November 2016.
“Trump would likely cause the stock market to crash and plunge the world into recession.” Simon Johnson, MIT economics professor, in The New York Times, November 2016.
“Citigroup: A Trump Victory in November Could Cause a Global Recession”, Bloomberg Financial News, August 2016.
Pretty impressive group. Smart! And more geniuses at the link.
Yet on November 7, 2016, the night before the 2016 U.S. election, the Dow Jones Industrial Average (“Dow”) closed at 18259.60 and the S&P500 (“S&P”) at 2131.52. One year later, the Dow closed at 23557.23 and the S&P at 2590.64. Not including investor gains from dividend distributions, a price gain in the Dow of 29% and S&P of 21.5%.
On July 5, 2019, the Dow closed at 26922.12 and the S&P at 2990.41. Again, not including distributions, the price increase since the election has been 47.4% in the Dow and 40.3% in the S&P.
How was following the “experts” as a strategy? Imagine if you moved everything into cash. Or, even worse, decided to short the markets in anticipation of a crash and/or global recession.
As someone who reads financial and business articles on a daily basis, this is the norm, not the exception with experts. The personal biases, political agendas, “herd mentality”, populist takes, or the extreme opinions to generate clicks, etc. All contribute to poor recommendations.
So yes, the lack of down market protection is another legitimate concern for buy and hold. But the bigger issue is, will you be able to correctly predict major market movements?
Buy and Hold Only Works if You Are Immortal
If you adhere to modern portfolio theory, you believe that in the long run, appreciating assets increase in value based on certain factors. And, as we saw in my second link above, this has held true for the last 100 years in all major asset classes.
But that may require an extremely long holding period. One not all investors can maintain.
Many investors do not seriously begin to invest until they are in their early 40s. If they need to liquidate at 65, 20 years may not be a long enough time frame. Had you invested in the Dow Jones Industrial Average at its peak in 1929, it would have taken 25 years for the Average to recover after its losses in the early 1930s.
Additionally, almost all investors have financial objectives covering different time periods. If you are 30, you may have a 35-40 year time horizon until retirement needs arise. You can take a longer term, higher risk perspective. But you may also want to buy a home in 3 years and finance your child’s education in 15. For short and medium term time horizons, you need to factor in other variables for your portfolio and strategies.
One’s investment time frame is relevant to the potential success of a buy and hold strategy.
These three concerns are common when you read articles on buy and hold investing.
These concerns suggest that active management is better than passive. But if active tends to not outperform passive, how can you protect your portfolio in volatile or bear markets?
We will consider this question in my next post.
by WWM | Jul 3, 2019 | Buy & Hold versus Active Trading
If you search the internet, there are plenty of articles critical of the buy and hold investment strategy.
So why do I suggest you employ buy and hold?
Some negative articles do not tell the whole story. The data is cherry-picked to “prove” the author’s point. Always raise a red flag when unusual start and/or end dates are chosen for data.
Some disadvantages relate more to investing in individual, non-diversified assets, rather than the low-cost, highly diversified, fund strategy that I espouse for most investors. A valid issue.
We will review the negatives often raised in conjunction with a buy and hold strategy.
Some are legitimate concerns. Some less so.
Today, the more frivolous.
It’s Too Easy a System to Employ
True.
Taken literally, you buy and then hold until you reach your target date. Then liquidate.
Not that there is anything inherently wrong with this approach. In fact, the ease of buy and hold can be seen as an advantage.
The problem with ease, is that like with dollar cost averaging, too many people believe this system should be used in the literal sense.
They buy, then they forget all about the investment until the time comes to liquidate.
The ease of buy and hold makes certain investors lazy. That is the problem. Not the ease of use.
Regardless of the asset or system employed, investments must be monitored and evaluated. Should circumstances change, portfolio modifications must be made. As well, if your personal situations shifts, you will need to adjust your investing plan. This applies to any trading strategy, including buy and hold.
Buy and hold cannot be rigid dogma. While you will adhere to it for the most part, there must be some flexibility allowed.
We have already discussed how to build a portfolio that minimizes the need to review and make adjustments. That is by primarily investing in low-cost, well diversified, index funds. As we saw, components within indices change over time. Even if your index fund is a buy and hold asset, there may be substantial movement within that index over time.
While minimizing the review process, it does not eliminate the need for periodic evaluations. Nor may it entirely avoid making any dispositions. We will consider portfolio reviews in future posts. Both when and how to evaluate your portfolio, as well as portfolio modifications.
Buy and Hold is Not Sophisticated
So it cannot work well. One needs a complex investing system to succeed. Preferably one with lots of technical data and charts.
Or so some people believe.
Sometimes the simple approaches work well.
But they are not sexy. And, for most investors, it is the lack of sexiness that is the bigger negative than a lack of complexity.
You will sound much more sophisticated as an investor discussing butterfly options strategies around the office water cooler, than in recounting how you have owned the same index fund for the last 15 years.
I suggest you worry less about how you are perceived by colleagues and friends. The purpose of investing is to maximize long-term wealth accumulation. It is not to impress your peers.
Find a strategy that works and stick with it. The grass is not always greener, or more profitable, on the other side of the trading fence. And the people that regale you about profits from their latest trading flips, never seem to mention the ones that lost money.
Buy and Hold Can be Emotional
Another two edged sword for the buy and hold approach.
As an advantage, buy and hold is supposed to take the emotion out of investing. You buy and hold through the ups and downs of the asset’s price fluctuations. You ignore the panic generated by the mass media during bear markets or sudden crashes. You are secure in the knowledge that over the long run, your investment will appreciate.
But this approach is also a disadvantage for many investors.
Holding an investment as month and after month its value diminishes is extremely difficult. In some cases, the value never comes back and you lose.
I can definitely empathize.
The difficulty as an investor is that you seldom are certain which investments will fall to nothing and which are just temporarily depressed.
Do you sell and wait for the asset to reach its bottom before buying back in? How do you know when the bottom has been reached?
Do you sell and shift your cash into another investment vehicle? Will that new asset provide better returns?
Again, find well-diversified and well-managed investments. These will help keep you sane during periodic market fluctuations.
Avoid non-diversified assets (e.g., individual stocks or bonds) until you become comfortable understanding the difference between normal short to medium term price volatility and the permanent impairment of the asset’s value.
Programmed Trading Makes Buy and Hold Obsolete
Computer trading programs are quite popular these days.
More effort is being spent on technical analysis. That is, these programs look at supply and demand for an investment. What are the pricing trends, momentum, and market bands. This type of information is used to assess future price movements.
While some technical analysts take a longer term view of the trends, many try to take advantage of short-term discrepancies that resolve themselves quickly. This can lead to substantial trading and profits can be made on penny fluctuations in market prices.
An argument against buy and hold is that with all the computer models and short-term trading, buy and hold is no longer relevant. The real money is made in the short term and not in holding assets for 20 years.
I do agree that programmed trading by institutions has, and may continue to, caused problems for investment valuations. I think though that these are short-term blips and that over time, asset pricing reverts to its fair value. This actually bodes well for the buy and hold strategy.
I am not a big believer in individuals using computer trading techniques.
I have known certain investors who have done well identifying price discrepancies and short-term trends to arbitrage. But usually you need significant capital to profit on small price changes. This is something that most investors lack.
These investors are also highly skilled and experienced in investing. They use advanced analytical tools. They also devote substantial time to their trading activities. Most normal investors lack the knowledge, tools, and time required to implement these strategies.
I remain unconvinced that, on average, programmed trading by individuals works. As I said, I do know some success stories. And occasionally, one reads news stories about others. But I also know and read about people that win the lottery. That does not mean everyone does.
Okay, those are a few of the less important, but commonly perceived, disadvantages of the buy and hold strategy.
Not really legitimate worries in my mind.
But there are a few real potential problems with buy and hold.
We will cover those next time.
by WWM | Jun 26, 2019 | Buy & Hold versus Active Trading, Investment Strategies
There are advantages and disadvantages to the buy and hold investment strategy.
I will review the pros and cons. Then you can decide for yourself if buy and hold is right for you.
After, I shall discuss possible tweaks that build on buy and hold’s strengths while addressing legitimate concerns.
Today we will review the benefits of buy and hold.
I Generally Like Buy and Hold for Investors
I may be a tad biased as I advocate essentially a buy and hold strategy for long-term investing.
But remember that I normally recommend passive investing. The objective is to create a well-diversified investment portfolio with the focus on cost minimization and matching market returns. Dollar cost averaging should generally be utilized and the investment horizon is relatively long.
Because of this, I typically recommend investing in low-cost index funds, open ended mutual or exchange traded, for most long-term investors rather than individual stocks and bonds. Especially for investors with relatively small portfolios.
As we will see over the next few posts, buy and hold (with a few tweaks) should usually work well when investing in low-cost diversified funds.
If investing in individual assets that lack built in diversification (e.g., common shares of AT&T, Deutsche Bank, Cathay Pacific, etc.) and are subject to nonsystematic risks, the buy and hold strategy may not work as well. But that is not our focus at this time.
Okay, on to the perceived advantages of the buy and hold approach.
Easy To Understand and Implement
Buy and hold is an easy investment system to employ.
You identify strong assets with long-term growth potential, acquire, then hold them throughout your investment horizon.
No need to constantly monitor and trade as the short-term trends and volatility dictate.
Consistent with Investment Theory
Conventional investment theory supports buy and hold investing.
Over the long run, higher risk assets outperform lower risk assets, on average. Historical data shows this to be true.
Of course, at times one requires a very long time frame to see this out. It took 25 years for the Dow Jones Industrial Average to recover from its highs of 1929 and subsequent crashes. Had you been 30 or 40 years old and invested the bulk of your assets in the late 1920s, a buy and hold strategy would not have brought you success.
While it works in the long run, realize that long may not be 5 or even 10 years. And why you need a diversified portfolio that reduces risk as you approach your target time.
Less Emotion, More Discipline
Two things I like in investing. Keeping the emotions to a minimum and maintaining a disciplined investment approach.
Without worrying about short-term price fluctuations or general market volatility, a buy and hold strategy will help you stay the course.
And combined with dollar cost averaging, you may actually come out ahead by acquiring subsequent assets at sale prices.
Passive Investing Outperforms Active
We covered this issue previously in some detail.
How active management compares to passive investing.
The relatively few scenarios where active investing may be appropriate.
And why active investing tends not to outperform a passive approach over time.
The ability of even professional investors to time markets or consistently pick the best individual investments is doubtful.
Most of you reading this do not have the technical training, investment experience, analytical tools, access to information, nor the time to study investments that the professionals do. If they cannot outperform using an active approach, should you even want to try?
Do not worry about attempting to get in and out of investments to capitalize on price fluctuations. Instead, find quality assets and take a buy and hold approach.
Less Costly Than Active Trading
While transaction fees have fallen substantially over the years, there is usually some price paid when trading. The more you trade, the greater the costs. And the more you pay out in expenses, the less you keep in your own pocket or have to reinvest for compound growth.
A significant cost that many do not fully factor into their calculations is taxation.
Unless your money is sheltered in a tax exempt or tax deferred account, you will be responsible for taxes owing on any realized gains (and in some instances on unrealized profits). The more frequently you trade, the sooner you (hopefully) trigger capital gains, and the sooner you must pay the tax man. Once you have paid your taxes, that is less money that can compound on your behalf over time.
You are usually much better off delaying payment of tax as long as you can.
In general, I agree with these advantages.
At a more detailed level though, there are a few caveats to the buy and hold strategy.
Some of these caveats, and the need to tweak the traditional buy and hold system, is due to potential disadvantages.
Of these negatives, we will review next time.