Rodney Johnson | Tuesday, August 27, 2013 >>
In 2003 when my son was in elementary school, I received a note from his science teacher. It turned out he had chosen not to turn in a project and write a paper. These were deliberate choices, as his teacher had reminded him they were due.
I was unhappy, to say the least.
When I pointed out that he currently had a C in the class and that I was angry, he was confused. “A 72 is still passing, right?” he asked. “Of course it’s still passing, but you can do better!” I (kind of) yelled at him. “If a C is not a good grade, then why is it passing?” he asked.
Dang it. I was put on the defensive by the logic of a 10-year-old. I hate it when that happens.
From here I had to go through all of the reasons why earning an average grade would count for almost nothing.
Yes, it would allow him to pass from one grade to the next, but it would not give him the freedom of choices that come with exceptional grades, and it would earn him none of the satisfaction and accolades that accompany high achievement.
He remained unimpressed, but he responded quite well when I outlined the punishments for what I consider to be poor grades.
All of this came to mind as I read the financial papers at the end of the second quarter. There were loads of articles touting the returns of the major indices, with much gloating about how buy-and-hold investors, particularly those that simply buy index funds and hang on, have done so well this year.
It struck me that this point of view is really in favor when the markets are up, particularly when there has been a multi-year positive run… but what happens next?
We are in year five of a market clearly distorted by the actions of the Federal Reserve. While there are certainly arguments about the size of the distortion, there should be zero debate about the fact the distortion exists.
This artificial boost to the equity markets has resulted in all-time highs for indices across the board.
Both of these things – Fed intervention, which could be on the verge of slowing, and markets at such high levels – should be seen as huge, flashing warning signs. Yet market pundits tout that readers and listeners should abandon all analysis and simply jump on the buy-and-hold index train.
From where we stand, it looks like that train is about to derail. And even if it doesn’t, is it worth the potential risk to your wealth?
We would love for buy-and-hold investing to work because it would be so simple. Investors would have no need of financial analysis, and major chunks of Wall Street – from analysts to salesmen to traders – could be dismantled. What’s the point of providing research or persuasion if buying a boring basket provides a decent outcome?
The problem comes down to timing. While buy-and-hold, on average, might work out in the long run, there can be substantial periods where such an approach would lead to disaster.
There was an entire decade (the 1970s) where buy-and-hold was death for a portfolio. Shorter periods, like the early 1980s, the early 2000s and, of course, the recent financial crisis were equally damaging.
The unspoken caveat of buy-and-hold, or average investing, is that it works out as long as you don’t need the money. If, during a down period, you can leave the funds invested, then it might work out. Maybe.
But how many investors are in such a position? How many people can take the attitude that if their portfolio tanks, they can simply leave it for as long as it takes – a year, two years, or a decade – until it recovers?
I guess such investors can exist, but if they do, they must be few and far between. Most of the investors I meet are more cautious with their funds, and would rather not see their portfolios fall in value for an extended period of time.
With corporate earnings tepid, GDP growth weak, the markets near all-time highs and the Fed’s plans in question, now looks like a pretty good time not to be average.
Ahead of the Curve with Adam O’Dell
Buy-and-hold worked great while Baby Boomers drove the U.S. economy and stock market from the early 1980s to 2007. But with demographics in the developed world now pointing down, investors with a penchant for growth and the ease of a buy-and-hold strategy are looking elsewhere.