Tuesday, November 30, 2010

Malkiel On "Buy & Hold" Equity Strategies

Earlier this month, Burton Malkiel wrote a persuasive editorial in the Wall Street Journal entitled 'Buy and Hold' Is Still a Winner. He begins by writing,

"Many obituaries have been written for the investment strategy of buy and hold. Of course, investors would be better off if they could avoid being in the stock market during periods when it declines. But no one—either professional or amateur—has ever been able to time the market consistently. And when they try, the evidence shows that both individual and institutional investors buy at market tops and sell at market bottoms."

It's a useful reminder. Many investors, including professionals, panic in a sharply-falling market and exit, only returning after the bottom has been touched and significant gains have already begun to be seen in the equity market indices. Malkiel goes on to assess some of the facets of equity markets of the past decade,

"Stocks and mutual funds were liquidated in unprecedented amounts at market bottoms in 2002 and 2008. Professional investors had large cash holdings at market bottoms but tended to be fully invested during market tops. Buy and hold investors in the U.S. stock market made an average annual return of 8% during the 15 years from 1995 through 2009. But if they had missed the 30 best days in the market over that period, their return would have been negative. Market strategists called for a sharp market decline in late August 2010 as technical indicators were uniformly bearish. The market responded with its best September in decades.

While no one can time the market, two timeless techniques can help. "Dollar-cost averaging," putting the same amount of money into the market at regular intervals, implies investing some money when stocks are high, but also ensures some buying at market bottoms. More shares are bought when prices are low, thus lowering average costs.

The other useful technique is "rebalancing," keeping the portfolio asset allocation consistent with the investor's risk tolerance. For example, suppose an investor was most comfortable choosing an initial allocation of 60% equities, 40% bonds. As stock and bond prices change, these proportions will change as well. Rebalancing involves selling some of the asset class whose share is above the desired allocation and putting the money into the other asset class. From 1996 through 1999, annually rebalancing such a portfolio improved its return by 1 and 1/3 percentage points per year versus a strategy of making no changes."

I can vouch for Malkiel's basic concepts. My own research has confirmed what anyone can find who closely examines the S&P500 Index. It rises in roughly 2/3 of months, with significantly long and deep losses only rarely. Thus, it pays to usually be invested long in equities. Dollar-cost averaging, combined with rebalancing,
allows an investor to amass more assets/dollar, and take profits in a regular, disciplined manner, to spread out among all the other assets.

Further, it's a little-known truth that most actively-managed funds don't beat the S&P500. Malkiel observes,

"As Jack Bogle, founder of the Vanguard Group, says: "In the investment fund business, you get what you don't pay for."

The evidence is clear. Low-cost index funds regularly outperform two-thirds of actively managed funds, and the one-third of actively managed funds that outperform changes from period to period. Even the very few professional investors who have beaten the market over long periods of time—Berkshire Hathaway's Warren Buffett and Yale University's David Swensen, for instance—are quick to advise that investors are likely to be much better off with simple low-cost index funds than with expensive actively managed funds.

The chart nearby illustrates how someone who invested $100,000 at the start of 2000 and, following my advice, used index funds, stayed the course and rebalanced once a year, would have seen that investment grow to $191,859 by the end of 2009. At the same time, someone buying only U.S. stocks would have seen that same investment decline to $93,717."

The above is sadly accurate. For most investors, disciplined, frequent asset purchases and rebalancing of inexpensive, available index products will deliver a much higher expected return than chasing the last year's hot actively-managed funds. The latter strategy pretty much guarantees buying at the tops of those funds, then selling at the bottom to buy the next year's winners.
Instead, as Malkiel concludes,
"The diversified portfolio, annually rebalanced, produced a satisfactory return even during one of the worst decades investors have ever experienced. And if the investor also used dollar-cost averaging to add small amounts to the portfolio consistently over time, the results would have been even better."
Even in the past decade, according to Malkiel's findings, investors would have enjoyed positive returns which would have outearned investments made and left in the S&P500 at the decade's beginning.
'Buy and hold' isn't a totally passive approach. But it's disciplined, limited activity, using only index products, can pretty easily outperform most active funds and an unmanaged use of those indices.

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