Active money management or buy and hold?

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With so much volatility in the stock market, investors saving for retirement must decide what investment approach may work best over the long term. Some market players question the wisdom of a “buy and hold” investment strategy, embracing active management instead.

The debate is not new, but perhaps it’s become more heated after the roller coaster ride of the past decade.

Before making fundamental changes to your investment approach, here’s what you need to know about active money management versus buy and hold.

The argument for active management

Supporters of active money management say that buy and hold is not a good long-term investment strategy for the small investor. They note that the most recent decade was not the only period of time that stocks — the assets favored in buy-and-hold portfolios — underperformed other, less risky, assets.

For example, from 1966 to 1982, the S&P 500 produced no real return (meaning it did not keep up with inflation), underperforming one-month Treasury bills by 0.2 percent per year. From 1966 to 1988, U.S. large growth stocks consistently underperformed one-month CDs.

“There’s really nothing new about buy and hold being a terrible investment strategy,” says Ken Solow, chief investment officer and senior partner of Pinnacle Advisory Group and author of the book “Buy and Hold Is Dead (Again).”

“The underlying theoretical proposition for buy-and-hold investing, which is the idea that stocks outperform bonds and cash over long periods of time because markets are efficient … all of that has been disproved. Markets have shown that they aren’t efficient, investors aren’t rational, and … when you buy stocks that have become expensive, you have minimum hope of achieving expected average returns.”

Today’s investors can no longer afford to put large sums of money into expensive assets, he says. This environment calls for tactical money management, especially if we are in the cyclical, long-term bear market that Solow fears has already begun.

At the core of his money management strategy is tactical asset allocation, one of many types of active management strategies. This one involves a diversified portfolio that includes multiple asset classes with percentage weightings that change as the market moves or as the perception of the market’s risk changes. This portfolio can change from day to day, and what it consists of one week may not be what it consists of the next.

“Asset classes are evaluated to ensure that the portfolio is diversified and then they’re assessed for their relative risk. … If the risk is lower in one asset class than another, we might add to the lower-risk asset classes and take profits out of the higher-risk ones … to tactically manage risk,” he says.

Portfolio assets, Solow says, should change as market valuations change, the market cycle changes, or investor technicals and momentum change.

Unfortunately, finding a qualified investment manager who understands and successfully practices tactical asset allocation is not easy. Morningstar doesn’t have a category for tactical asset allocation funds, so there’s no way to evaluate how they perform relative to their peers.

The case for buy and hold

Buy and hold is the mantra of famous investor Warren Buffett. This investment strategy can involve individual stocks or passively managed funds.

“Buy and hold became a successful strategy because it moved people away from trying to time the market,” says Chris Farrell, economics editor for American Public Media’s weekly “Marketplace Money” radio show. “Timing the market is hazardous to your wealth. None of us has a crystal ball that can tell what’s going to happen in the market in six months.”

In a buy-and-hold portfolio, stocks or funds are bought and held for a long period of time. While there may be short-term fluctuations (business cycles, inflation, etc.) over that period, over the long term all of those economic ups and downs level out as the market as a whole rises. Most importantly, trading costs, fees and commissions are considerably lower with this investment approach, and taxes can be reduced or deferred by buying and selling less often.

“It’s not simply ‘buy and hold,’ but ‘buy and hold, rebalance and tax-manage,'” says Larry Swedroe, principal and director of research for The Buckingham Family of Financial Services, and author of seven investment books, including “The Only Guide to Alternative Investments You’ll Ever Need.”

“It’s never been buy-and-hold-and-forget,” he says. “You need to adapt to changes, you need to annually review your investment plan to make sure that its underlying assumptions haven’t changed significantly over the past year, and you make changes that are reflective of those as they happen.”

Stocks will always have a risk component, says Swedroe. However, it is that same risk premium that has also made them such a historically successful and rewarding long-term investment.

Both Farrell and Swedroe favor using low-cost, low-turnover index funds over actively managed funds.

“Properly buying and holding a well-diversified portfolio of passively managed stock index funds, both domestic and international, is one cost-effective way to participate in the growth of the global economy,” says Farrell.

Standard & Poor’s keeps a scorecard of how its indexes perform relative to active funds, and there are no clear victors since the results can be interpreted favorably by proponents of both investment approaches.

Over the five years ending in December 2009, the majority of index funds outperformed active funds in all but two of 17 domestic fund categories. The two exceptions: large-cap value funds and real estate funds.

However, when assessing asset-weighted returns (meaning a fund’s returns are weighted by its total assets), S&P found active managers level or ahead of indexes in all but two categories: mid-caps and emerging markets.