Is “Buy & Hold” the Way to Approach These Markets?

In Part I, it was suggested that one should stay in markets, even though there appears to be substantial downside risk…[because] no one really knows what is going to happen and the opportunity cost of missing an upside move can be large…This article (Part II) evaluates the use of a traditional buy & hold, diversified investing strategy while Part III evaluates the merit of using a simple momentum-based switching system.

You reasonably ask, [however,] “Suppose the market craters?” That is a real risk, especially given today’s economic situation. Should I stay in markets if we are on the verge of another version of a dot-com bust or housing collapse? Both caused markets to drop over 50%. The graph below illustrates the severity of these corrections:

Today looks eerily similar to the points which preceded both collapses. No one wants to go through this kind of adjustment yet they are part of the risks of participating in markets. These patterns repeat; we just don’t know when. Unfortunately they appear to be coming more frequently.

A Bad Drop

What happened in 2008 was especially bad and sudden. The SPY dropped 55% in less than a year. It was a very vicious decline.  As such, it provides a good scenario against which to stress test trading strategies.

Simple Buy & Hold Strategy

To keep matters simple, assume there are only two assets: SPY (ETF for S&P500) and EFA (ETF for broad collection of International, i.e. ex-US, companies). Each is well-diversified within the geographical boundaries they represent. We begin with a portfolio of $10,000 on January 1, 2007 (or today if you assume history repeats).

Investors choose an allocation between these two broad asset categories based on their preferences. For illustrative purposes, only three allocations are reviewed. These included the two extremes of 100% in one or the other of the choices and then a 50% allocation to both. The returns from January 1, 2007 through March 26, 2013 from the buy and hold strategy are as follows:

• All SPY              25.8%
• Half SPY – Half EFA  11.0%
• All EFA      <3.7>% (LOSS)

The results, as expected, reflect the overall performance of markets during this period. To be polite, one can characterize them as poor. The returns seem more applicable to a one-year holding period than a six plus year span. It is difficult to recover from drawdowns of 50% which both ETFs incurred. Both had nice recoveries afterward although EFA closed with a small loss for the total period.

Let’s look at the pattern of equity over time. All US (100% SPY), All International (100% EFA) and an equal allocation between US and International are shown in the graph below:

PORTFOLIO EQUITY

For actual investors who went through this period with diversified portfolios, the results above are likely to be fairly representative. The high correlation among assets and asset classes limited the ability of diversification to help, at least diversification within stocks. That is apparent by how the equity curves above track one another.

Given the pain that began around the 20^th month onward, one wonders how many investors actually stuck with whatever strategies they intended. When losses mount, the tendency is to take money off the table. Some reduce exposure by taking some funds out of markets while others take everything out. Those who didn’t stay with the buy & hold strategy did worse or better, depending upon their timing and nerve. Did they re-enter the market at a point below where they exited? Some undoubtedly did, but most probably did not.  Fear is a paralyzing emotion and there was a lot of it during this sell-off.

In Part III a simple momentum-based strategy will be reviewed. This strategy provides better returns and less risk. It is less emotional as a result of lower draw-downs and provides a mechanical discipline that reduces the danger of making decisions under emotional stress. The results are quite impressive.

Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.

*http://www.economicnoise.com/2013/03/29/stay-in-markets-part-ii/ (© 2013 Monty Pelerin’s World)

Related Articles:

1. Part I: There Will Be a Time to Flee the Stock Markets But Not Just Yet – Here’s Why

My answer to the issue of staying in or getting out of markets is to stay in. This answer is independent of whether a correction is imminent or a few years down the road because we cannot possibly know that information….There will be a time to completely flee markets. It is just not now or at least I don’t believe so.

2. Part III: Using a Momentum Investing Strategy Is the Way to Go – Here’s Proof

In volatile markets you must be able to go to cash when markets become dangerous. That is exactly what the momentum selection model does well. It protects your capital on the downside and enables it to grow on the upside! If you insist on staying in the stock market at all times, even perfect foresight cannot protect you. The ability and willingness to periodically run away beats the macho strategy of holding on.

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