July 29th, 2013
In the previous article, I accused investment managers of encouraging their clients to “focus on the risks of losing principal rather than on opportunities for portfolio growth“. I suggested that their aim was to match what you identified as future demands on your finances “with various funds they believe will minimize the risk of your not having the full amount when it was needed.”
This was reinforced to me when I came across an article in MarketWatch, entitled “The Ultimate Buy-and-Hold Strategy” by Paul Merriman in which the author states that his approach works “in portfolios big and small, doesn’t rely on predictions or require a guru or special knowledge of the markets or economy.” He claims that his overriding goals are to build portfolios that deliver returns that exceed those available in “industry standard 60%stock/40% fixed income allocation” portfolios while subjecting investors to no additional risk as measured by the standard deviation of the Portfolio’s fluctuations.
To prove that his portfolio had returns greater than 8.5% and a standard deviation of no more than 11.6% (the long-term experience of a typical “industry standard portfolio”), Merriman assumed creating a hypothetical $100,000 in 1970 and allocating the funds into index funds and exchange-traded funds. He concluded that over 40 years, “by far the biggest contributor to investment success (or lack of it) is your choice of asset classes.” In other words, it’s not when you bought but what you you bought and that you not trade any of the individual securities during the period that improved results.
The conclusion sounded similar to notions I’ve heard over the years from the Efficient Market Theory crowd, the folks I wrote about extensively in my book, Run with the Herd. According to the theory,
“Many investors think success lies in buying and selling at exactly the right times, in finding the right gurus or managers, the right stocks or mutual funds. But being in the right place at the right time depends on luck, and luck can work against you just as much as for you. Your choice of the right assets is far more important than when you buy or sell those assets. And it’s much more important than finding the very ‘best’ stocks, bonds or mutual funds.”
Merriman takes a step-wise approach to assembling his “ultimate” portfolio by starting at the 60/40 mix and then adding higher return, lower volatility asset classes in relatively arbitrary proportions. He then measures how much $100,000 would have grown to over 42 years, rebalancing the portfolio annually to keep the percentages fixed and what the volatility (how much the portfolio might have fluctuated over the period) might be. The process results in the following model portfolio (right column is the end result):
The advice offered by most investment advisers is similar to Merriman’s Ultimate-Buy-and-Hold Portfolio: assemble a portfolio of a diversified list of ETFs or mutual funds (which translates into hundreds or thousands of individual securities) and hold it for the long run (20 to 30 years). It doesn’t matter when you by only that you hold the portfolio long enough for economic growth to make up any and all bear market draw downs (i.e., losses). So the trickiest part of the Ultimate Buy-and-Hold Strategy is matching the right level of risk for each individual investor’s financial needs, in other words, the most important asset-class decision an investor makes is what percentage that investor should have in stocks and how much in bonds to his portfolio’s volatility to his future financial needs.
The final makeup of the Ultimate Buy-and-Hold Strategy is in the right-hand column and this hypothetical portfolio would have generated an average annualized return of 10.5% (compared with the 60/40% portfolio return of 8.0%) with a much lower volatility (11.7% vs. the standard portfolio of 17.0%) over 42 years. However, at the end, Merriman discloses the caveats (my emphasis added):
“Every investment and every investment strategy involves risks, both short-term and long-term. Investors can always lose money. The Ultimate Buy-and-Hold Strategy is not suitable for every investment need. It won’t necessarily do well every week, every month, every quarter or every year. As investors learned the hard way in 2007 and 2008, there will be times when this strategy loses money….. this strategy requires investors to make a commitment. If you are the kind of investor who dabbles in a strategy to check it out for a quarter or two, this strategy probably isn’t for you. You may be disappointed, and you’ll be relying entirely on luck for such short-term results….. [the strategy] is not based on anything that happened last year or last quarter. It’s not based on anything that is expected to happen next quarter or next year. It makes no attempt to identify what investments will be “hot” in the near future…. strategy is designed to produce very long-term results without requiring much maintenance once the pieces are in place.”
But here’s another catch! According to Merriman, ” the best way to implement this strategy is to hire a professional money manager who has access to the institutional asset-class funds offered by Dimensional Fund Advisors (DFA).” So is the study unbiased? Is it self-serving? Was there be any doubt as to what the study’s conclusions would say?
There’s wisdom in the saying “timing is everything” or it wouldn’t have survived for as long as it has? You could still be trying to break even on a portfolio of large tech stocks like Cisco, Oracle, Microsoft, Ebay and Amazon had you bought them in 2000, at the peak of the Tech Bubble. If you had bought your home in 2006 hoping that it would continue increasing in price and some day be your retirement nest egg then you’d have to put off retirement since it fetches a 10% lower price today. You could have sold the gold coins inherited from a grandparent for $750/ounce in 2009 thinking the precious metal prices just couldn’t possibly continue increasing but recently discovered that it hit a peak of $1700 just two years later. Or you might be that person who continues buying long-term government bonds today without questioning whether the secular bull market in fixed income securities be close to peaking; let’s ask them whether timing is important 3-5 years from now when his principal had declined 35% in value.
Timing does matter for individual securities, it matters when it comes to your portfolio and it matters for your financial well-being. Portfolio management should be an active process not a passive one. It’s a cop-out for investment advisers to tell you to predict your financial needs but not to try to predict the returns and future value of your investments. There is an alternative. There is a difference between predicting and reacting and it’s the same as the difference between gambling and managing your investments. Market timing isn’t predicting the market’s future direction, it’s reacting to changes in the market’s trend as you see them taking place. Strategies like the Ultimate Buy-and-Hold Portfolio doesn’t sound like management to me. It sounds more like gambling that my portfolio isn’t depressed due to a bear market just when I need to unexpectedly withdraw funds or for planned needs.
The next article will focus on various types of risks and their relationship to portfolio management.