Financial Literacy - Retirement income planning
Walter Woerheide
retirement
Buy-and-hold investing not dead after all

But if you just define your population of investments to begin with as including these alternative investments, it is perfectly consistent with modern portfolio theory.

q_v2.gif And what do you think about the ubiquitous question, is buy-and-hold dead?

a_v2.gifNo, absolutely not, and it never will be. It comes back to the fact that anybody who thinks they are going to outguess the market is going to be wrong as often as they are right.

There is one study I remember that set up something like, at the start of each quarter you could peek ahead and see if stocks went up or down. If they went up, you put your money into stocks and if they went down you put your money into T-bills for that quarter.

If you had 100 percent perfect forecasting, you did better than a buy-and-hold strategy.

Then they came back and said, "What percentage of the time do you have to be correct in order to beat buy-and-hold?"

They found you had to be correct about 80 percent of the time to beat a buy-and-hold strategy. That is a lot.

It's really tough, then, to correctly guess looking ahead for the coming quarter to see if the market is going to be up or down 80 percent of the time.

And also let me point out that it turns out that over the course of a year, there are about 20 days in which most of the big moves occur. And if you are out of the market when those big moves occur, you're really going to underperform that year.

The biggest danger in trying to guess the market is being out when the market makes a big jump.

When the S&P fell to 1,500 two years ago, down to about 700 last March, everybody that guessed that it was going to go down still further and got out at 700 have now missed an incredible run-up of nearly 50 percent.

So the frustrating thing is that you can always look back and say: If only I could have gotten out here or gotten in here. And if you try to translate that into the future and say, I'll just figure out what the market is going to do -- people can't do it.

And every time you are jumping in and out, you're paying commissions. If you're a taxable entity -- to the extent you have capital gains taxes -- you're producing some taxes that you have to pay which reduces the size of your portfolio.

And so there is a very real cost to trying to be an active portfolio manager.

q_v2.gif So would you recommend a passive approach for individual investors?

a_v2.gifAbsolutely. Individual investors need to understand what their investment horizon is. They need to figure out the asset allocation categories, and that may include some alternative investments. I don't oppose them.

For instance, REITs (Real Estate Investment Trusts) as a vehicle for real estate investments, TIPS (Treasury Inflation-Protected Securities) for inflation protection. A lot of nontraditional stock and bond holdings can make sense. They just have to figure out what that optimal allocation is.

The only caveat about buy-and-hold: If you have an asset allocation strategy, over time as different assets go up and go down, your actual allocation will change from your optimal allocation.

In a bull market, let's say that you decided that your optimal allocation was 60 percent stocks and 40 percent bonds, then suddenly stocks are 75 percent of your portfolio.

A simple buy-and-hold strategy would say, I'm not at the optimal allocation, but I'll leave it. True portfolio theory would say sell stock and put more money in bonds.

Complete buy-and-hold may make sense if your portfolio is something like 100 percent stocks.

But as soon as you start defining your optimal portfolio in terms of asset categories, buy-and-hold doesn't mean buy-and-hold.

There have been several studies that have actually shown that if you do rebalance on a regular schedule, you end up with better performance in terms of return and risk exposure.

q_v2.gif That would seem to be counterintuitive.

a_v2.gifI can say that although I consider myself to be somewhat of an expert in investments, I wish I had followed that advice myself.

You get into behavioral finance. Your stocks start doing incredibly well and you get blinded by that and say, "I'm going to ride this one out."

We all hope to get the Walmart in its infancy or Google or things like that -- you buy them and they go up and if you sell, you're missing out on incredible price appreciation.

When you have something that does incredibly well, you think it's going to be the next Google or Walmart. But it probably won't and that means you need to rebalance and go back to your classical asset allocation.

q_v2.gif So have a plan and stick to it.

a_v2.gifYes. But it's painful to stick to the plan when your stocks start going through the roof.

 

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