If investors could be granted a single wish, it would be this:
Let me know when stocks are rising, so I can be in
— And let me know when stocks are falling, so I can be out.
Surely, there must be some way to know when the market will rise and when it will fall.
Either way, they get paid today, and you live with the results tomorrow.
No reader will want to hear this, but in more than 40 years of investing, “buy and hold” is the only strategy I’ve seen that appears to work. It’s painful. It fills us with fear. But if you hang in long enough, it works. If the drops are too scary, there’s only one thing to do: change your long term asset allocation to include more fixed income and less in equities— and then hold that.
One indication is Warren Buffett. Hedge fund managers rise and fall, hot hands in mutual funds come and go, but Mr. Buffett is the guy who made billions with his favorite holding period for stocks: forever.
Not convinced by a single anecdote? Good. Here’s some powerful evidence.
Comparing fund turnover rates. In the June issue of Financial Planning magazine, Brigham Young University professor Craig L. Israelsen offered some evidence that buy-and-hold” outperforms market timing and other trading strategies. Examining returns of the last 3, 5, and 10 year periods for large blend funds, international funds, and U.S. bond funds, he divided the funds in each group into the 25 percent with the most portfolio turnover and the 25 percent with the least portfolio turnover. He then assumed that the high-turnover funds were trying to make tactical changes to avoid market ups and downs while the low-turnover funds were “buy-and-hold” funds.
In each time period, in each case, the low turnover funds beat the high-turnover funds. Over the 10 year period ending in December 2009, the low-turnover funds returned an annualized 1.0 percent while the high-turnover funds returned an annualized loss of 1.2 percent. That’s a spread of 2.2 percent a year. The 10-year annualized performance gap for the international funds was 1.6 percent. The performance gap for the bond funds was smaller at 0.2 percent, but it still consistently favored the low-turnover funds.
We can quibble about this, of course. It is possible portfolio turnover is too broad a metric to identify the managers who make regular tactical decisions to be in, or out, of the market. Even so, it confirms that anything leading to high portfolio turnover can be dangerous to your financial health.
Using a simple buy/sell rule. Researchers at Dimensional Funds tested a popular idea— using a simple moving average as a buy/sell signal. Many investors do this as a guide for both individual stocks and entire asset classes. Dimensional compared buy-and-hold against a strategy of investing when an asset class rose above 102 percent of its 10 month moving average and selling when it fell below 98 percent of the same measure.
From 1927 through 2008 the simple moving average rule returned an annualized 10.75 percent. The buy-and-hold portfolio returned 11.67 percent. Buy-and-hold beat the moving average strategy by 0.92 percent. Annualized over 81 years that’s a major advantage. They noted, however, that the buy-and-hold investor had to live with more market volatility than the investor who was leaving the market when prices were declining.
Examining timing gap performance. In a 2007 research paper Mercer Bullard, Geoff Friesen and Travis Sapp, professors at the University of Mississippi, University of Nebraska and Iowa State University, respectively, measured investor performance in mutual funds. They focused on actual investor performance in the funds based on the timing of investor purchases. They found that investing in actively managed funds sold through brokers led to the largest performance gap over simple buy-and-hold index investing. Examining the period from 1991 through 2004, they found the gap for all active funds was 1.7 percent a year. That was more than three times the 0.47 gap for index investors.
Their conclusion: “Our results sound a warning to fund investors who are considering whether to attempt market timing, either on their own initiative or through their broker’s advice.”