Is buy-and-hold fool's gold?
The Dough Roller explains why this approach to retirement savings works for him.
Last week my family had dinner with good friends of ours. After dinner our conversation turned to investing. Our friends told us about a money manager they were going to use to manage a small portion of their investment portfolio. The wife was fed up with the buy-and-hold investment strategy, she told us, and was looking to become more aggressive with their investments. I cringed.
The money manager charges 2% of invested assets and regularly takes short positions (bets against the market). He is also partial to ProShares, a mutual fund that uses leverage to boost returns (and losses!), as if investing weren’t risky enough.
Anyway, the wife’s basic beef with long-term investing strategies was that the market over the past 10 years had failed to produce positive returns. In her view, the market goes up and down, but in the end, finishes right where it started. One might say the market is "full of sound and fury, signifying nothing."
While I can certainly relate to her frustration, I’m still a big believer in the buy-and-hold strategy. So I thought it would be a good time to discuss what buy-and-hold investing is, and why it's the approach I follow.
Buy-and-hold investing is a long-term investment strategy that largely ignores market volatility. One way to understand buy-and-hold is to imagine you’re trying to hit a golf ball over a pond and onto a green. The pond is the market volatility. It may look scary, but if you hit the ball far enough (or invest long enough), you’ll clear the pond with no worries.
Now let’s apply buy-and-hold to the market freefall we felt last year. For buy-and-holders, a 40% decline in market value one year is at worst a distraction. It’s certainly no fun to watch your investment portfolio tank, but if you are investing for the long term, the market value of your investments in any given year is unimportant. Last year my investments were down 35%. This year they are up 24% so far. Who knows what next year will bring, but since I’ve got 20-plus years to retirement, the current value of my portfolio is nothing but a number on a computer screen.
Asset allocation is critical
For buy-and-hold investors, asset allocation is critical. Asset allocation is the investing equivalent of ensuring that all your eggs aren’t in one basket. By investing in a mix of stocks, bonds, and cash, you can lower the overall volatility of your portfolio while at the same time maximizing your returns. Remember that returns are a function of risk, and with asset allocation, you can control the risk of your portfolio.
In my 20s, my portfolio was invested 100% in stock mutual funds. Today I’m in my mid-40s and have lowered my investing risk by gradually moving 30% of my investments into bond funds. As I get older, God willing, I’ll continue to move a greater percentage of my invested assets into bonds.
Why is asset allocation critical? It’s critical because it will help you weather the financial storms that are sure to develop. Put all your money in one stock or one fund or one asset class, and you’ll be far more inclined to sell in a down market. Think of asset allocation as insurance against you doing something stupid with your investments.
Take advantage of down markets
I hope you see 2008 as an important learning opportunity. Carefully evaluate how you reacted to the falling market. Did you sell all of your stocks? Did you keep your stocks, but stop investing? Or did you stick to your investment plan, ignore the market, and go play catch with you son or daughter?
How you handled 2008 is really important in figuring out how you should invest going forward. In fact, if you sold your stocks out of fear of the falling market, consider the following:
- Asset allocation: As noted above, the proper asset allocation is critical to buy-and-hold investing. It may be that you were taking too much risk or just not paying enough attention to your investments. While asset allocation by no means guarantees gains each year, it does allow you to control a potential downside given your risk tolerance.
- Money managers: As you probably guessed from my reaction to my friends hiring a money manager, I'm not in favor of the idea for the vast majority of us. I manage all of our retirement investments and taxable accounts we have with an online brokers. Still, sometimes we are our own worst enemies when it comes to investing. If you find yourself doing stupid things with your portfolio, a money manager who charges 1% to 2% to manager your money may be a good investment.
- Learn from 2009: I know several people who pulled out of the market at the end of 2008 and early 2009, and now they deeply regret that decision. They've missed out on the returns of 2009, and now wonder when they should get back into the market. The takeaway here is to realize that the market goes up and down. It always will. Don't let short-term volatility, no matter how dramatic, dictate your investment decisions. As Warren Buffett puts it, in the short term the market is a voting machine; in the long term it's a weighing machine.
When (if ever) do you sell?
Buy-and-hold does not mean that you never sell an investment. In fact, there are many good reasons to sell:
- Rebalancing: There are times when you need to adjust investments to maintain your desired asset allocation. If there is a run-up in stocks, for example, you may end up owning more stocks than you intended. I generally rebalance my investments about once a year.
- Changing asset allocation: As we get closer to our investing goals (typically retirement), we need to change the allocation of our investments. In most cases, this means reducing our exposure to equities and increasing our exposure to bonds and other forms of debt. The rule of thumb is that your stock allocation should equal 120 minus your age (others use 100 minus your age). Whatever approach you take, it will require adjustments to your portfolio from time to time.
- Taxes: For retirement accounts, taxes are not typically an issue until you start using your money in retirement. But for investments in taxable accounts, taxes are extremely important. Last year, I sold my interest in Vanguard International Explorer (VINEX) because it was generating a lot of taxable gains each year. One might ask why I invested in the fund in a taxable account in the first place, and the answer is simply -- it was a mistake. It was many years ago, and I've learned a lot about investing since then. But the point is that tax considerations can and should influence your investing decisions in taxable accounts.
- Retirement: For many, it will be necessary to use retirement investments to pay for expenses during retirement. This will require selling investments, of course. By this time, however, your asset allocation will be very conservative, and most if not all of your yearly expenses will be coming from conservative bond funds and cash accounts.
- Macroeconomic considerations: I do think it's important to consider the big picture. Fifty years ago, international investing was unnecessary. For a host of reasons, including technological, investing in foreign issues was not as easy as it is today. And U.S. investments, given the growth of the U.S. economy, made for great long-term investments. Today, exposure to foreign investments is critical. And as the U.S. government proves unwilling to control spending, the falling dollar may make foreign investments all the more important.
What's your take? Is buy-and-hold the best approach for most of us, or do you think market timing is the answer?
Related reading at The Dough Roller:
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