Is buy and hold a better way to invest?
QI keep reading that “buy and hold” is a much more successful way to invest than stock picking.
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Q I keep reading that “buy and hold” is a much more successful way to invest than stock picking. If it's that simple, why can't I do the same thing without paying a fund fee?
A You are correct that “buy and hold” is better than stock picking, but don't read “buy and hold” literally — there's much more to it.
Buy: Investment allocation is responsible for over 90% of the difference in return from one portfolio to another. That means it isn't just holding on, it's buying the right things in the first place. Are you diversified into the right areas (asset classes) in the right amounts? Which has the best risk-return ratio among stocks, commodities, bonds, real estate, and futures?
There are a million ways to do it wrong and never know that your risk is too high or your return too low until it's too late. If your risk is too high, your short-term returns will be fine sometimes, but will crater at other times. Note that this is a subjective determination. What you define as “crater,” someone else may call normal.
If your return is too low, there are two options. One: You're not meeting your financial goals, so you're in trouble. Many investors don't realize they're in trouble because they don't know what their goals should be. Two: You may be meeting your minimum financial requirements but leaving a lot on the table. Again, many investors are in this predicament, but they don't look for help because they don't know they could do better.
Hold: Holding is also not as simple as it sounds. As stocks fluctuate, a portfolio will drift away from its original allocation. How much it drifts will depend on the relative performances of each asset class. In a year like 2007, where over 50 percentage points separated the top and bottom, this drift makes a big impact. Effective holding means rebalancing: periodically readjusting the portfolio to maintain the target asset allocation that was created to match the risk-return objectives. Recent findings have shown that rebalancing can add annual returns of more than 1.25% for a given level of risk. But that's only if it's done right.
Imagine three concentric circles. The target allocation is in the center. Beyond the center is a boundary encompassing the target range, and beyond that is a value that will trigger rebalancing.
The first question is where to set the boundary and the trigger — how much drift to allow. Rebalance too soon, and extra transaction costs and taxes are incurred. Rebalance too late, and too much risk is taken. Plus, the answer is different depending on asset class and tax status of the account.
The second question is how much to rebalance. Do you reset back to the target or just within the boundary? Research conducted by the Mercer Advisors Investment Committee in 2006 shows that rebalancing back to the edge of the boundary is more beneficial than rebalancing back to the exact target allocation.
If we rebalance back to the edge of the boundary, that provides the asset class with a band in which it can move and still not trigger rebalancing, hence avoiding unnecessary transaction costs and taxes. This process not only improves the expected return, but also increases the Sharpe Ratio (risk-adjusted return) for the portfolio.
The third question is how to rebalance. Investors think of rebalancing as selling this to buy that. However, rebalancing can be done much more profitably by managing cash flow during deposits and withdrawals. This may sound easy, but there are algorithms that define the optimal placement of funds into and out of each asset class based on movement and volatility — it's not guesswork.
Cash flows are not the only thing to consider when rebalancing portfolios. Taxes, transaction costs, and dividends further complicate this “simple” process. While taxes might not be a big constraint for tax-deferred accounts, they may be a significant drag on a client's taxable portfolio. Is it better to sell a stock that is about to declare a dividend or use the dividend to rebalance?
This is the real power of buy and hold and what it takes investment professionals years to master.
References available upon request.
Gene Dongieux is the author of “If You Have It Made, Don't Risk It: A Physician's and Dentist's Guide to Investing.” As chief investment officer for Mercer Advisors, he manages more than $3 billion in client assets. Dongieux has been quoted in The Wall Street Journal and Investment Advisor magazine. Contact him at email@example.com.