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The case for buy-and-hold
Modern asset allocation is the evolution of buy-and-hold and market timing philosophies
By PHILIP LOH
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Published January 31, 2007 |
ASKED what was the most important thing he learned from mathematics, Albert Einstein said: 'Compound interest. It's the most powerful force on earth.' And a buy-and-hold strategy takes advantage of this powerful force.
Those who believe in buy and hold would advise picking an index fund and making monthly investments until you retire. They claim that successful investors are buy-and-holders just like billionaire Warren Buffett who recommends that one buys good companies and holds them forever.
The 20-year relative performance: Buy a basket of good quality shares and hold for any 20-year period. Statistics show that this strategy always out-performs bonds, gold, cash, real estate or most other investments over a similar time period. Then again, most investors do not typically hold their positions for more than 10 years. Long-term investors are a small portion of the investment community. Missing the best days: Unless you are in the market all the time, you are in danger of missing the best days that account for a huge portion of the stock market's gains. For example, if you invested $100 in the US stock market in 1926 and held them through 2005, your investment would be worth $200,000. But if you tried to time the market and missed the 30 best months, your $100 would have grown to only $8,000. But what if you are in the market all the time except for the 30 worst months from 1926 through 2005? Your $100 initial investment would have grown to $19 million.
Taking the what-if game further, what if you had missed the 30 best and the 30 worst months? It would have grown to $320,000, and with a lot less anxiety. Buy-and-hold guarantees that you don't miss the best days of the market but be prepared to give some of the gains back during the bad days.
Its Siamese opposite - market timing does not work: A recent published study exhaustively tested and compared market timing and buy-and-hold strategies, using data from 1926 through 2002. It analysed a variety of market timing strategies, producing more than one million different outcomes. Each outcome was then compared to the buy-and-hold strategy for the same time period.
The results showed that market timing failed to beat buy-and-hold in over 90 per cent of the scenarios. Mark Hulbert, publisher of the Hulbert Financial Digest which tracks 170 market timing newsletters, found that over 80 per cent of newsletters underperformed their market indexes.
The fact is that we are not statistical robots. Buy and hold works for people with the discipline to stay the course. Unfortunately, many investors panic during bear markets and dump losing holdings, often doing more harm than good to their portfolio. 'They end up being worse off than someone following a statistically inferior market timing strategy, but who's willing to follow that through an entire market cycle,' noted Mr Hulbert.
Bad timing does matter: An interesting study released in 2004 showed that investors tend to buy high and sell low, chasing winners in bull markets and dumping laggards in bear markets. During a 19-year period from 1984 through 2003, the average US equity investor earned an anaemic annual return of 5 per cent, versus 12 per cent for the S&P 500. Mutual fund investors are not better off. The average S&P 500 index fund did about 11 per cent. After charges, the average actively managed unit trust returned about 10 per cent. Coupled with bad timing, the average mutual fund investor earned just over 6 per cent per annum.
Compounding can work for or against you: A columnist from TheStreet.com, James 'Rev Shark' DePorre, whose motto is 'Saving souls from buy-and-hold', commented that compound interest can work both ways. If you buy a momentum stock that went bust, it could go down all the way, 'compounding your losses year after year'.
If you are among the investors still recovering from the tech wreck of 2000, you should know that it takes a 100 per cent gain just to break even after a 50 per cent loss. Hence, it may be wise to avoid losing money at all costs.
The best of both worlds: I feel that buy-and-hold and market timing need not be mutually exclusive. In fact, modern asset allocation is the evolution of buy-and-hold and market timing philosophies, exploiting the potential from both schools of thought.
In asset allocation, the strategist chooses a selection of funds he believes would provide the greatest opportunities for appreciation. However, it is impossible to capture the whole spectrum in the portfolio. Various sectors are constantly being over-weighted or under-weighted depending on when profit from outperforming funds is shifted to better opportunities in 'undervalued' sectors or regions.
This active asset allocation process is market timing in disguise. The portfolio remains fully invested in a mix of equity and bond funds. The actual mix would depend on the investor's risk profile. The 'fully invested' dogma derives from the buy-and-hold principle.
Unless your portfolio consists only of a global equity fund, the asset allocation process involves a certain degree of market timing. For example, why Japan equities and not US equities? Why emerging Europe and not pan-Europe? All allocation decisions involve judging the 'right time' to invest in a particular asset class. A static allocation model akin to the buy-and-hold strategy is seldom advocated as there are fewer avenues for the financial adviser to add value to justify the ongoing portfolio management fee.
However, financial advisers often abuse the term 'asset allocation' by highlighting its overwhelming impact on portfolio returns - a point which is both evident and often irrelevant. To suggest that your returns will be improved by asset allocation is reminiscent of Mark Twain's advice: 'Buy good quality common stocks and hold them until they go up. If they don't go up, don't buy them.'
Asset allocation faces some real challenges. Different investment strategies outperform under some circumstances and under-deliver in others. Therefore, picking the right funds is inherently harder than picking the right stocks. Most portfolio strategists select funds with strong past performance and may end up investing into previously strong styles or sectors which ultimately regress and underperform.
Moreover, timing uncertainties can be longer than clients' patience, which leads to career risk - which is why a fund manager never wants to be wrong alone. Strategists' efforts to reduce career risk then create herding, momentum and extrapolation, which eventually leads to underperformance when markets correct sharply.
The baseline assumption that the stock market is dominated by the big boys explains why many actively managed portfolios under-deliver in the longer term. The big boys in the market are the investment banks and hedge funds. Mutual fund managers may be big players, but their mandates require them to stay largely fully invested and thus are price takers rather than price makers.
Outperformance is only possible when we successfully time the market with consistency. To deliver alpha or out-performance over the index return, cost and profit need to be inflicted on some losers.
The financial statements of the investment banks show that they are generating above 20 per cent annual returns on their trading activities. It is no wonder that the CEOs of many top investment banks on Wall Street are former star traders. Profits from the trading desks often constitute more than 50 per cent of total earnings (including contribution from traditional activities like underwriting, M&A, fund management, lending and leveraged buy-out deals). They outperform the general market by tens of billions of dollars a year. If the investment banks are collectively the winners, then who are the losers contributing to their alpha?
Compounding the challenges of asset allocation is the high cost of owning unit trusts in Singapore. The fund management business in its totality (assuming everyone invests in actively managed unit trusts) creates no 'value' (defined as outperformance of the index) but costs about 2 per cent a year (average expense ratio of equity based CPF-approved funds). If the world consists of only managed funds, professional fund managers must collectively underperform because of their cost. It's like a poker game in which the good player must inflict his costs and profits onto the loser. To beat the index by 2 per cent, someone must lose by 6 per cent every year.
Assuming Singapore equities give a long term return of 8 per cent annually, it would drop to 6 per cent after offsetting fund expenses. Under wrap account structures, the average fee is about one per cent a year. That leaves us with a 5 per cent return on the equity portion of the portfolio. If a sizable portion of the portfolio is invested in bonds, the annual return may be lower. For non-wrap unit trust accounts, there is usually a bid-offer spread of 2-5 per cent, which would reduce the effective return by 0.5 to one per cent annually, depending on the length of investment.
Some investors decide to spare themselves the agony and park their savings in fixed deposits, currently yielding about 3 per cent. Others choose to invest in blue chip STI stocks and enjoy the stable dividends and capital gains over the years. Many investors have lost faith in fund managers' ability to generate any meaningful return in the long run.
Unless active asset allocation plans can demonstrate clearly how they can out-manoeuvre the market in the long run, they are just added fees. Most would be better off holding a global equity fund like classic buy-and-holders. It may seem boring, but it's definitely more rewarding.
The writer is a chartered financial consultant with Great Eastern Life. He is writing in his own capacity |
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