Focus on the Long-term and You Will "Sleep Better at Night"
By Pierre Fournier
I received a note last week from a student who took issue with my ‘buy and hold’ investing philosophy. “It usually works over the long term, but not always,” was the way he put it. He also said there are no “hard rules” around investing and that investors need to think outside the box. “Only the savvy short to mid-term traders will be making money in the times ahead.”
In this volatile, go-go market, the tried and true methods are vulnerable to criticism. But before we throw Warren Buffett's "buy and hold approach" and time-tested principles under the bus, we need to understand the critiques and test them against an appropriate time frame. In the case of buy and hold, we first need to define it.
For some, it means buying a dozen dividend stocks and tucking them away. Or never selling your beloved iPhone. For the purposes of this article, buy and hold refers to investors who stick to a target asset mix. For example, a 60/40 investor who keeps the equity content of his portfolio at 60 percent in all types of markets.
Stay Focused on the Long-term
It’s a certainty that our 60/40 investor will experience short-term losses when stocks drop significantly. No amount of diversification will offset market forces.
By the same token, he can be assured that when the recovery comes, he will also participate. Over longer periods, the chart of his portfolio will go up and to the right, with lots of zigzags along the way. A steady flow of dividends contributes to this trend.
Investors who are timing the market, or shorting it, are swimming against this "up and to the right" stream. They need to be extra diligent at implementing their strategy.
It is important to point out that the downdrafts can be severe at times. After the great financial crisis in 2008, market indexes like Canada’s S&P/TSX Composite took four to five years to get back to their 2008 highs.
There are, however, two problems with this statement. First, these indexes don’t represent an investor’s experience. They are price indexes and don’t include dividends. Total return indexes, which do, recovered in half the time.
Also, the S&P/TSX Composite is not like a typical portfolio that has exposure to fixed income and non-Canadian stocks. Bonds increase in value in bear markets and the Canadian dollar tends to drop, which moderates the weakness of foreign stocks. Well-diversified portfolios declined much less in the financial crisis and earned back their losses in 18 to 24 months.
There’s a perception that buy-and-hold investors can’t take advantage of opportunities when markets are down. The assumption is their portfolios are static. In our 60/40 example, however, this is only true with respect to asset mix. The holdings that make up the portfolio will adjust and evolve over time. Moves are made to keep the portfolio on the plan, most of which fall into the category of rebalancing.
This year, for instance, our 60/40 investor needed to add to stocks in March after they dropped below his target level. If he was truly rebalancing, he would have added to stocks or funds that were down the most. Today, any contributions would be allocated to fixed income.
Outside the box
The key to any strategy, buy and hold included, is to give it a chance to play out. You can’t hop on and off and expect to be successful. This doesn’t preclude you from switching to another approach that fits your personality, skills and needs better, but wholesale changes should be done rarely and with careful thought.
It can be expensive to switch from indexing to trading stocks, or focusing solely on low-volatility stocks, or trying to time the market (i.e. trading commissions, transfer fees, and capital gains taxes) and there’s often a short to medium-term performance shortfall. Numerous studies have shown that when pension funds hire new investment managers, the fired ones do better on average than the shiny new ones in the subsequent few years.
The buy-and-hold approach has been out of vogue before and will be again, but it has a lot going for it. It’s simple to implement and, just like Mr. Buffett's ideas and other investment tenets, has served investors well over many decades.