Is Buy and Hold Not Working? Part 3

“Being a buy-and-hold investor today makes as much sense as it ever did. The point of sticking to sound, fundamental strategies, after all, is to keep you from making big mistakes in moments of crisis. And abandoning the market now could turn out to be a very big mistake.” – Jeremy Siegel.

Roger C. Gibson, the author of Asset Allocation: Balancing Financial Risk was recently interviewed by Morningstar Advisor to offer his perspective on the turbulent stock market of the last year. Gibson is an expert on portfolio construction and investment management. His observations are worth considering.

No Place to Hide in 2008

Morningstar’s data base includes approximately 4,000 mutual funds that invest in either stocks or real estate (U.S. or international). All but one had losses in 2008.

“Of 1,730 bond funds–both taxable and municipal–68% lost money, which surprised us. Those that didn’t were (U.S) government or short term bond funds.”

“I’ve never seen losses like 2008, but it wasn’t something completely unthinkable. And when you have absolutely horrible, panic-driven significant losses, they’re usually not just confined to a particular asset class. In 2008, panic fed on itself.”

Volatility

Gibson tabulated the number of days the Standard and Poor’s 500 gained or lost 5% or more. Between January 2008 and August 2008, there were no 5% days. Between September and December there were 18 days when the market moved 5% or more, or one out for five! This is unprecedented volatility.

It is quite amazing how investors have become accustomed to 5% fluctuations in a single day. According to Gibson, “Over the last 50 years, these kinds of moves probably only happened once a year and, already, investors have almost gotten numb to this volatility.”

What can we learn from 2008?

“During times of excessive optimism, people overshoot markets on the high side, and during times of extreme fear and panic, markets overshoot on the downside. In 2008, people panicked and dumped securities, which sets the stage for higher-than-normal rewards for people holding on.”

Regarding asset allocation and diversification, “Strategic asset allocation isn’t broken and never promised to sidestep a year like 2008, but what it will do is make the portfolio as a whole have less average risk. That’s mathematically driven. And it will cause a portfolio to have a higher compound return than the average return of its asset classes. That said, it doesn’t mean you can’t get into a scary environment.”

Conclusion

In previous posts, I have written about the futility of trying to predict the near term direction of the stock markets. It just can’t be done successfully on a continuous basis, neither by you, on your own, nor with the help of a market strategist. I’ve also written about the near impossibility of improving your overall results by pulling out of the market and waiting until you think it’s a better time to invest. Finally, I have outlined the evidence for the failure of market selection – finding underpriced securities.

Given what does not work, what is the recommended approach? In my opinion, it is a diversified, low cost, buy-and-hold portfolio matched to your time horizon and risk tolerance.

To be continued.