Is Buy and Hold Not Working? Part 2

My last post addressed the proper response to a stockbroker’s claim that the “Buy and Hold” approach to investing has not worked. My answer was, “compared to what?” I explained that, in determining when you should and should not invest in stocks, the probability is low that you’ll guess right.

By the way, have you noticed that the question of whether “Buy and Hold”  works only comes up after a steep market decline? Why doesn’t it ever come up when stock prices are hitting new highs?

Since we have covered the issue of when to buy, up next is what to buy, or more specifically, what approach to use in investing for the long term.

Active Investing

A perennial debate (actually, only since the 1970’s, but you get the drift) among investors is which is better, active or passive investing. Wall Street (stockbrokers) must convince you that active investing is superior, or they have little to sell. Their sales pitch is usually that their experts can do better than average. Think about it. All stockbrokers and active money managers say the same thing. How is it possible that they all claim to achieve better than average returns? Do they live in Lake Wobegon?

What they are claiming is that, through superior stock selection, they can outperform the market. The strategy is for an investment manager to buy something that is underpriced and will do well. After it has outperformed, sell it and then buy something better. This approach is certainly good for the stockbroker, who earns a commission on each and every trade, or the mutual fund company, which can charge higher fees for active management.

But there is no evidence that anyone can actually do it profitably on a consistent basis. Let me rephrase that a bit, there is no evidence that a stockbroker can do it consistently and profitably on behalf of an investor. Certainly, the stockbroker consistently profits from the commissions he earns while actively trading on an investor’s behalf.

Regarding mutual funds, remember that active trading has costs; the cost of research, trading, and taxes, for a taxable account. Therefore these mutuial funds have to overcome the higher costs before their investors benefit at all from active management.  That is true in good times and bad. In fact, many actively traded mutual funds have had a really rough time in this bear market, underperforming stock indexes.

For a witty (though somewhat wonkish) take on the active versus passive debate, consider a transcript of Rex Sinquefield’s opening statement in a debate with Donald Yacktman at the Schwab Institutional conference in San Francisco, October 12, 1995.

For a more recent comment on the issue, one professional investment management firm that manages billions of dollars and uses the asset class mutual funds of Dimensional Fund Advisors, summarized it well.

“Let’s be very clear: this bear market has been witness to the spectacular failure of active management. Index funds have handily outperformed active managers in a market where conventional wisdom would have you believe the active approach would add value. When (you) read that now it is more important than ever to be tactical, it begs the question that if active management didn’t help you avoid this bear market, then why would you expect it to outperform going forward?”

Conclusion

When an active investor attempts to identify and buy a stock or bond that is underpriced, what he or she is really saying is that everyone else is wrong. That’s because the current price is the best estimate of what everyone thinks it should be. It’s true that prices can be wrong, and that they can and do eventually change, but the question is whether you, or anyone else for that matter, can identify and take advantage of any mis-pricings in advance of their correction.

The same applies when choosing a successful mutual fund investment manager. It would be wonderful if we could find really good stock pickers, the ones who consistently beat the average, but that is impossible. You may find that sometimes (about 25% of the time) a mutual fund has beat its benchmark. Unfortunately, you cannot identify such winners in advance.

To be continued.