Weekly Update

March 25, 2016 Update

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Buy and Hold investing

Passive investing involves buying index ETFs or funds of varying asset classes in some predetermined target mix, such as 60% of a portfolio invested in stocks and 40% in bonds. The investor focuses on buying this portfolio at the lowest possible costs, holding the ETFs/funds indefinitely while occasionally making minor adjustments to keep the portfolio near its target mix. The challenge in following a passive investment approach is setting aside our emotional response to a market under severe pressure. Seeing your account balance dropping 20% is difficult for most of us to stomach. We believe investors do not have to suffer through those gut-wrenching declines.

Though not typically in the form of passive investing, the vast majority of investment advisors and brokers preach the wonders of buy-and-hold. It is industry doctrine and much print is devoted to convincing clients that buy-and-hold is the only rational approach to investing. As trend-timers we have largely rejected the buy-and-hold mantra of the investment industry. Why do we reject it? This week, we’ll explore some of the more common arguments presented to support the buy-and-hold investment approach and our contrarian view of those arguments.

Buy-and-hold argument 1: despite the ups and downs, the stock market generates a significantly positive return over time. Investors should stay invested for the long-term and take advantage of this natural tendency for stocks to go up as the economy grows.

This is certainly true. Stocks DO tend to go up over long periods of time. Chart 1 below shows that over the past 100 years, stocks have generated an average annual return of about 10%. The chart also shows the variation in returns over various rolling periods of time. For example, over any 10-year period, stocks have almost always delivered a positive return with some 10-year periods offering almost a 20% return. Of course, stocks just concluded a rare “lost decade” where the return was negative. Over any 20-year period, stocks have never given a negative return. Hopefully, that statistic continues.

Chart 1: Range of Stock Market (Dow) Returns (for holding periods from 1 to 100 yrs)

Range of Stock Market (Dow) Returns (for holding periods from 1 to 100 yrs)

If an investor is now 20-30 years old and has decades of investing ahead of them, perhaps there is some comfort to be taken in these long-term averages. However, if an investor is recently retired without enough resources to last, they can ill afford a 10-20 year period of single digit annual returns. In summary, the stock market delivers a solid return over long periods of time. But those returns can vary dramatically over shorter periods of time, even to the point of being negative for entire 10-year periods. Having just gone through such a “lost decade”, it seems highly unlikely such performance will be repeated, however.

Buy-and-hold argument 2: missing the 10 best days in stocks dramatically reduces returns. Thus, investors must stay the course in order to be present for these critical days.

This argument is trotted out frequently to support buy-and-hold. And the data can look pretty compelling. To whet our appetite for buy-and-hold riches even more, let’s take the most recent secular bull market from 1984-2000, a period where stocks offered an enormous 17.89% annual return. $100 invested at the beginning of 1984 would have grown by almost 14x by the end of 1999. So, what’s the impact of missing the biggest up days? Table 1 below shows the impact of missing not only the best 10 days; but extends that to the impact of missing the best 20 days, best 30, and 40 days. The effect is dramatic. We obviously cannot afford to miss those key days.

Table 1: Missing best days impact

Missing best days impact

Okay, it’s obvious that missing large up days damages returns. What is usually missing in this argument is the other side of the coin: What if you miss the WORST days? It turns out the impact is far more dramatic than missing the best days.

Table 2: Missing best days versus missing worst days

Missing best days versus missing worst days

Chart 2: Growth of $100 from 1984-2000

Growth of $100 from 1984-2000

Almost every investor has heard the story of missing the 10 best days. How many have heard about missing the 10 worst days? And the data above was during the longest running Bull market of our generation. A period when buy-and-hold generated outstanding returns. Even during this stellar stock market period, the benefit of avoiding losses to preserve capital for future gains is abundantly clear.

Buy-and-hold argument 3: You can’t time the market. Just look at the dismal performance of professional mutual fund managers! As a group, they underperform the market over any extended period of time. If the best minds in the investing world cannot beat the market, why would you, Mr/Mrs Individual Investor, think that YOU can do it?

This one we won’t spend much time on. Many of the articles espousing this view focus on timing the market from one day to the next, which misses the point. Timing the market on a given day is not what any trend following strategy attempts to achieve. We acknowledge that it’s impossible to consistently call the tops or the bottoms. But that’s never our intent. We simply argue that taking a passive buy-and-hold approach to investing is a disaster, especially in a secular bear market such as we have been in. The data above shows that, while not a disaster, being mindful of avoiding losses even during a strong secular bull period can improve results handsomely. We feel that our results speak for themselves, and offer a very strong endorsement for the benefits of preserving capital and building wealth through a trend timing philosophy.

Buy-and-hold has its place for investors who do not have the knowledge, capability, or resources available to pursue any other strategy. But with the advent of discount brokers and the vast information available on the internet, excuses are far fewer than they once were. Spread the word: there are better ways to invest! You need not rely completely on the generous spirit of market forces to deliver your returns. After all, despite the market’s recent months-long run of gains, we have seen in the past and will see again that the market can be anything but generous.

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Market Update

After finally moving into positive year-to-date returns last week (Dow Jones and S&P500 indexes), stocks took a breather this week. On Monday stocks opened lower but managed to eek out small gains by the end of the day. Notably, biotech stocks, which have been in a sharp correction since last July, rallied sharply while homebuilders fell. Tuesday, sellers tried to take charge early on news of a terrorist bombing in Brussels, Belgium. Still, U.S. stocks closed only fractionally lower and European markets including Belgium, France, Germany, and the U.K. all managed small but noteworthy gains by the time those markets closed.
By the middle of the week, sellers finally got the upper hand with all major indices closing down in sympathy with a 2.1% decline in energy shares resulting from a 4% slump in oil prices. Risk assets and emerging markets fell the hardest, although pundits indicated declines were overdue as stocks globally have rallied sharply from the mid-February lows. Thursday, stocks again opened lower but stabilized throughout the day, with the major indices finishing essentially flat in quiet trading.

Warm wishes and until next week.