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Resistance is futile: Why buy-and-hold beats value investing — Pop Economics

Resistance is futile: Why buy-and-hold beats value investing

by Pop on February 16, 2010

Post image for Resistance is futile: Why buy-and-hold beats value investing

Hello Consumerism Commentary visitors! I’m glad I was able to write a guest post for Flexo. I’d be even more happy if you came by on your own! Here are a few reasons why you should:
 
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Or, why the best investing strategy isn’t the best for you

I love value investing. I really do. I’ve read books by Robert Shiller, David Dreiman, Benjamin Graham, and Warren Buffett (well, his letters, anyway), and I’ve come away with the sense that these guys, more than anyone else, know how to buy and sell companies. Value investors try to find strong companies, but wait to buy until their shares are cheap. Who wouldn’t agree with that as a solid investment strategy? In my mind, that’s way better than trying to find the next up-and-comer before they’ve proven they can make a dime, as some growth investors do.

But despite that, personally, I’m a buy-and-hold investor. Sometimes, I look at the market and just know it’s overpriced. But I still buy. Sometimes, I look at the market and know it’s cheap, but I buy the same amount. It’s a little paradox in my behavior, but over the years, it’s something I’ve grown more and more comfortable with. Because even though I understand the basics of how Warren Buffett does what he does, I know that I would be bad at it. Here’s why.

1. Valuing the market is not an exact science.

The absolute best valuation metric I have seen takes the price of the S&P 500 and divides it by an average of the last ten years of earnings. It’s a method that was popularized by Robert Shiller in his book Irrational Exuberance. The data on Shiller’s website goes back to the late 1800s and has been surprisingly consistent in predicting future market returns. But even a source of info as authoritative and robust as Shiller doesn’t allay my concerns. “Why?” you ask.

Well, what if we used the first few years of a human’s life to predict his future? When John was born, he weighed 8 pounds and was about 20 inches long. Now, at age five, John weighs 42 pounds and is 40 inches tall. Extrapolating his growth rate, at age 50, John will weigh 306 pounds and be 15 feet tall. See any problems here?

Put simply, the U.S. is a teenager. And save a few recessions and a depression, our growth trajectory has been steep. In the last 200 years, the U.S. went from insignificant start-up nation to hegemonic superpower. It only gets to do that once. And investing with the expectation that that kind of growth rate will continue indefinitely is pretty naive.

If the U.S. starts growing like a grown-up (i.e. not much and not rapidly), it’s hard to say what kind of effect that could have on market valuation. Investors could require a lower P/E ratio on stocks to make it “worth it” to them to invest. Maybe the real money in stocks would come from dividends instead of share price growth. Who knows?

2. The market can stay irrational for a long time.

And although the market’s average price-to-earnings ratio is about 15, it can spend long amounts of time really, really far away from that figure. It stayed below 13 between 1913 and 1927, reaching a low of 4.78 in 1920. It sunk to the single digits again in the 1930s, 1940s, and 1970s. Sure, I can see myself saying, “The market is cheap!” and buying as much as I could for a few years, but could I stick it out for fourteen years without questioning my methodology?

Or how about when the market is overpriced? The market’s price-to-earnings ratio stayed above 17 every month between May 1990 and the end of 2008. That means stocks were too expensive for nearly two decades, and I shouldn’t have bought a single stock. The 1960s and 1970s saw similar lengthy periods of overvaluation.

I couldn’t trust myself to stick to my strategy. The market’s long periods of irrationality would break me down the same way the Borg broke down nearly every race it encountered. I’d fall back. I’d resist. But eventually, the market would assimilate me. It’d only be a matter of time before I became one of the brainless many.

3. You only have to be irrational once to mess up.

Imagine the consequences of adopting a value strategy and changing your mind after a decade of seemingly contrary evidence wore down your resolve. You might have ended up loading up on stocks in the late 1990s. Or maybe you gave up on stocks in the early 1980s. Even if you did things the “right” way for years and years. That one mistake could have cut your wealth in half.

That’s the rub. Value strategies might work in the long-run, but they aren’t likely to work on your personal timeline. You’ll start needing your retirement savings when you hit age 66 (or whatever retirement date), no matter how irrational the market is in that particular year. So you’ll probably make decisions on buying and selling based on your own needs, despite market signals.

And that’s why I advocate buy-and-hold, even though I also believe value investing and the Shiller P/E are as close to “sure things” as there are in the market. Whereas value investing needs you to be on top of your game throughout your investing lifetime, buy-and-hold and asset allocation give you “mediocre” returns in exchange for the probability of not completely decimating your portfolio with a few bad decisions. Sure, you’ll hurt in times like the financial crisis. But you won’t hurt as much as if you half-assedly followed a smart strategy.

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{ 10 comments… read them below or add one }

Mike February 16, 2010 at 11:16 am

Really good points. I try to combine both value investing and buy-and-hold by investing in value index funds over the long haul.

An added plus: it’s just plain easier to sleep at night when you’re a buy-and-hold investor.

J.D. February 16, 2010 at 2:53 pm

I should have paid you to ghost-write the investing chapter of Your Money: The Missing Manual! :)

Rob Bennett February 16, 2010 at 6:20 pm

We’re on opposite sides re this one, Pop. I favor Valuation-Informed Indexing, which is a melding of Buffett’s Value Investing and Bogle’s Buy-and-Hold Investing. My view is that Buffett and Bogle go together like chocolate and peanut butter!

I do think you have presented a more modest and reasoned argument for Buy-and-Hold than I have read in lots of other places. I have a “Today’s Passion” feature at my site where each day I put up a favorite link and I am going to link to this article tomorrow as I would like my readers to hear a good statement of the other point of view.

Where I think you go wrong is in thinking of Buy-and-Hold as a neutral position. You are right that stocks cannot be valued precisely (it’s a lot easier with indexes than it is with individual stocks, but even with indexes we cannot identify proper values with precision). But following a Buy-and-Hold strategy does not really permit you to avoid valuation questions — what you are really doing (in my view!) is assuming that the market is always priced well enough to justify putting your money into it. I question whether that is a good assumption. At the prices that applied from 1996 through 2008, my view is that just about all non-stock asset classes offered a better long-term value proposition. The trouble is that Buy-and-Holders have a hard time believing this and cannot be persuaded because they are not willing to look at the numbers.

It can make sense not to make dramatic allocation shifts for the reasons you cite. But my belief is that you would be better off at least looking at the arguments put forward by those who focus on valuations so that you at least are aware of the extra risk you take on when you fail to take allocations into consideration when setting your allocation. At least if you know what you are getting into you will not be shocked by the long-term results you obtain.

Rob

Pop February 16, 2010 at 9:03 pm

@Rob: I knew you would! That post was Rob-bait if there ever was one
: ). But I’m glad you see where I’m coming from. It’s not that I think value investing is a bad strategy. I just think I would be bad at it. That said, some sort of tactical shift–that is, shifting my allocation by 10% in favor of or against stocks depending on valuation–is a different matter and maybe something I could maintain (and will address in a different post).

@Mike: By “value index fund” do you mean one like those at Research Affiliates or WisdomTree? Or do you mean some kind of fund that tracks the S&P 500 value index? I’d be interested in taking a look.

Mike February 17, 2010 at 12:03 am

@Pop
One of the small cap value index funds that I invest in is the ‘Vanguard Small Cap Value Index’. If you just search for small cap value, you’ll see a lot of different options.

Rob Bennett February 17, 2010 at 6:28 am

That post was Rob-bait if there ever was one : ).

Oh, my!

That said, some sort of tactical shift–that is, shifting my allocation by 10% in favor of or against stocks depending on valuation–is a different matter and maybe something I could maintain (and will address in a different post).

I look forward to the post, Pop.

Our difference is that I think of valuation shifts as strategic rather than tactical. IndexUniverse.com had an interview with John Bogle this Summer in which this particular aspect of the question came up in an intriguing way. Bogle started to say what you are saying here — that occasional tactical allocation changes based on valuations are okay. Then he stopped himself and said “Oh, I should say strategic, not tactical!” (that’s a paraphrase, not a quote).

That floored me because I have been arguing for years now that these shifts need to be strategic rather than tactical. An investor making a tactical shift in 1996 (when valuations first went to insanely high levels) would have lost out because we did not see a crash for another 12 years; he would have given up on his tactical move before it had time to pay off. An investor making a strategic shift in 1996 (a shift made because he wanted to keep his risk level roughly constant, not because he thought he knew where the market was headed in the next year or two) would be ahead today.

The entire historical record shows that tactical shifts never work (except by pure chance) and that strategic shifts always work (if implemented in a reasoned and moderate way). So I think this distinction is a big deal. I think that if people could come to understand the difference between tactical and strategic shifts, much of the confusion and friction we see evidence itself in discussions of this topic would dissipate.

The short-term future is unknown. So tactical shifts are really just rooted in guesses (they might work out, but there is no particular reason to believe they will). The long-term future is known (not perfectly, but to a statistically significant degree). So strategic shifts are certain to work sooner or later (so long as they are implemented in a reasoned and moderate way). Even in cases in which they don’t yield higher returns (they usually do), they help the investor stick to his strategic plan (part of which is the risk level he has chosen for himself). The only way in which strategic shifts could be a bad idea (in my view!) is if we live in a world in which the riskiness of stocks does not increase with increases in valuations (this is the world of the Efficient Market Theory, which I view as having been discredited by the academic research of the past 30 years).

The focus of the argument you make in the blog entry is on investor emotions and on implementation questions. These are legitimate points. The greatest theory in the world doesn’t work if it is not implemented properly. You are questioning whether it is possible to implement valuation shifts properly. I think it is possible but I also think that the point being made is a perfectly reasonable one. I wish that we saw more discussion of it. My view is that we will see more discussion of it when we get to a point where there is a consensus that there is enough merit to the idea of making allocation shifts in response to valuation changes that the idea is not dismissed without even it even being given consideration by a dogmatic claim that “timing doesn’t work.”

That’s the entire question in dispute — Are strategic shifts based on valuation changes a different form of timing, a form of timing that actually works?

My hope here is that there are some listening in who believe regardless of where they come down on these questions that you have “baited” a good discussion for all of us.

Rob

Rob Bennett February 17, 2010 at 8:51 am

After putting up my post above, I was making my rounds of the blogs and came across a comment that I think demands to be added here.

Rajiv Sethi is a Professor of Economics at Barnard College, Columbia University. Here is what he writes in an update to a blog entry entitled “The Invincible Market Hypothesis”:

“In a comment on the post (and also here), Rob Bennett makes the claim that market timing based on aggregate P/E ratios can be a far more effective strategy than passive investing over long horizons (ten years or more.) I am not in a position to evaluate this claim empirically but it is consistent with Shiller’s analysis and I can see how it could be true.”

http://rajivsethi.blogspot.com/2010/02/invincible-markets-hypothesis.html

Rob

Pete February 24, 2010 at 6:42 pm

At the risk of upsetting everyone, you might also consider using ETFs and a simple technical tool to evaluate your positions.

One easy method is to use the ten month moving average for your buy/sell signal. Review your positions on the first day of each month. If it is above the 10 month average buy it. If it is below the 10 month average sell it.

Always diversify across investment type and styles.
A few to consider:

SPY – S&P 500
LQD – Investment grade Corp bonds
JNK – Junk bonds.
XLE – Energy
IYR – Real Estate
FGB – Business Development Companies
EEM – Emerging Markets
DBA – Multi Sector Commodities
IGE – Natural resources
AMJ – Master Limited Partnerships
DBV – Currency Harvest fund
GLD – Gold

BTW, you might also like these two:
IVE – S&P Value
IJS – Small cap Value

You can find more ETFs here:
http://finance.yahoo.com/etf/browser/mkt?c=0&k=5&f=19&o=d&cs=1&ce=152

Don’t make it hard. Depending on how much money you have, start with the SPY and add to other sectors and classes.

Here is an easy to use charting site. Just set it to monthly. Add the 10 month simple moving average feature and enter your ticker.
http://bigcharts.marketwatch.com/advchart/frames/frames.asp?symb=spy&time=8&freq=1

K Smith February 26, 2010 at 1:26 am

It doesn’t make much sense to me to participate at all in a US dollar denominated market in an economy that at best will grow at 2% per year, with a world economy projected at flat growth.

Based on what I see as the future of the US dollar, gold and Canadian dollars are much better bets.

Josh March 24, 2012 at 2:29 pm

Very very good points. I tell people all the time that strategies that work for the pros, may or many not work for those less involved.

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