The Winklers had over $500,000 in their retirement portfolio – the result of a frugal lifestyle and saving every extra dollar they could. They would have to trim expenses further to make it work, but they were exhausted and ready to retire. The year was 2007. We all know what happened next. The stock market plummetted 53%. The Winkler’s portfolio – conservatively invested (or so they thought) – did much better and only lost 23%. Still, $128,000 disappeared and with it any chance to retire for many years to come.
The Winklers experienced “Sequence of Returns” or “Timing” Risk and 2007-09 isn’t the only example. 2001-02 was equally devastating. The Asian Crisis (1997) and the 1990 recession were significant (though not as dramatic) and of course the Crash of 1987 wiped out a third of portfolio values in a matter of a few weeks.
Buy and Hold Is Dangerous
The “Buy-and-Hold” approach to portfolio investment is often cited as the best way to manage investments. Unfortunately for you and most unsuspecting investors, it is far more likely to cause you harm than to help you, at least over the next 20 years.
I realize that statement flies in the face of a lot of what’s accepted as gospel truth in personal investing. It’s not been easy for me to come to this conclusion, either. I’ve been an investor most of my life. I’m classically trained (with a Masters) in portfolio construction techniques, have been drinking the “invest for the long term” Kool-Aid (from John Bogle, Burton Malkiel and others) for decades and have directly managed millions of dollars of client money since the Winklers walked in my door.
How could I say something like “Buy and Hold is dangerous?” Because it’s true. Here’s my perspective.
The Origins of the Buy and Hold Portfolio
Essentially there are two major styles of investment portfolio management: Passive and Active.
Buy-and-Hold portfolio managers are Passive. They set a strategic portfolio allocation and let it ride no matter what happens. They rely on Modern Portfolio Theory (MPT) – an academic paper written in 1952 by Harry Markowitz. From a purely academic standpoint, Modern Portfolio Theory is sound. If you know the expected return, volatility and co-variance of every asset in a portfolio (a much bigger “if” than MPT supporters suggest and a major point of struggle for Markowitz, himself), that portfolio mix of assets can be optimized to maximize gains relative to a desired level of risk.
MPT both validates and quantifies the benefits of diversification (which are real and undisputed).
The Problems with Passive
Supporters of Buy-and-Hold (what I like to call “Buy and Hope”) claim that this optimally diversified portfolio should never change – that the “right” asset allocation is a once-and-done, set-it-and-forget-it thing. I have more than a few issues with this approach and some pesky assumptions behind MPT. However, my two biggest complaints are that it (a) requires more time than most investors have to give and (b) forces human beings to endure more gut-wrenching pain than they can handle.
THE TIMETABLE PROBLEM – The math behind Modern Portfolio Theory only works when you have almost unlimited time and no need to draw funds for spending in any particular year. Shorter time periods (even 20 years) expose the investor to Timing Risk – starting the clock at the peak of a cycle (like the Winklers). Research by Robert Shiller (the PE10) and John Hussman suggest that real (inflation adjusted) gains for the stock market over the next 12 years are very likely (93% confidence) to be close to zero with plenty of big swings in the meantime.
This timing risk can upset expected returns for many decades although Rob Bennett‘s calculator shows that the worst effects are muted after 30 years … so if you have 30 years before you need the money, it may be that Buy-and-Hold is good for you.
THE HUMAN PROBLEM
Through those 30+ years, however, the investor (you) has to be willing to endure the ups and downs of their portfolio without wavering from their original portfolio allocation – not easy for humans to do when their account balance is off by 20% or more.
As an aside, I believe that a large part of a traditional investment adviser’s fee goes towards addressing this Human Problem. Once portfolio losses exceed 15%, the phone starts to ring with calls from clients who are freaking out and want to bail on their investment strategy. A large part of my time in 2008, 2010 and 2011 was spent “talking clients off the ledge” as we went through various market corrections. I wonder how today’s automated investment tools (which also rely on MPT) are going to address this very real Human Problem.
Active Portfolio Management
Obviously, Active managers don’t “let it ride.” I’ve found it easiest to think about Active management in terms of three basic sub-styles: Predictive, Reactive and Responsive.
- Predictive Portfolio Managers – try to guess where the market (or some subsection) will be and optimize the portfolio exposure accordingly. Subscription newsletters are part of this group as are most of the pundits you see in the financial media.
- Reactive Portfolio Managers – watch the financial media and react to what they see happening. If a stock has done well, they are buying it. If the market has performed poorly, they are thinking about selling. Most of their decisions are emotionally based and their portfolios reflect a herd mentality.
- Responsive Portfolio Managers – are tactical and follow a set of predefined rules and respond to what the market data is telling them.
The Active camp has it’s own problems. Predictive Active managers rely on market timing. Peer-reviewed academic research proves that market timing does not work consistently and that the additional costs create an insurmountable drag on performance. Morningstar and Dalbar have released studies which suggest that Reactive buying and selling – chasing market returns – also hurts investors (although some of those studies’ conclusions are disputed).
Tactical – A Better Way
The Responsive Portfolio Management approach is built upon a series of rules – if this happens, then the manager will do that. Yes, the manager is responding to recent market data but this response is not Reactive (herd mentality). Rather, it is based on mathematical probabilities. For money that may be spent in the next 3 to 30 years, a Tactical approach is more appropriate than a Passive Buy-and-Hold strategy. It is also psychologically superior for anyone who cannot stomach the losses that are built into a traditional passive portfolio.
If you want to test out your current downside risk exposure, you can go through our Quick (2 questions) Portfolio Risk Inspector tool (free).
What’s the Objective?
The most important point to understand when working with ANY portfolio manager is their objective. Any viable (rules-based) strategy can only be designed to optimize ONE objective. Buy and Hold is rules-based with the objective of optimizing long term (30+ years) risk adjusted returns. Other portfolio manager objectives might be to maximize short-term gains, limit volatility or (as in my case) limit large losses. You can then measure the manager’s success relative to their objective.
In the case of Buy and Hold, you’ll have to wait 30 years to see if you picked a good manager … or you can find a different approach that is on a timetable more appropriate to you, your life and your financial plan.