Will the Great Recession Trigger the End of Buy-and-Hold Investing?

by Millionaire Mommy Next Door on May 3, 2009

in Economy,Investing

More specifically, does the commonly given investing advice to “buy and hold” really work?  Or have the rules changed?

During the past several decades, the prevailing advice has been something like this:

“Diversify your investments, buy stock in good companies, and hold them until you retire. The value of stocks (and real estate) always go up over time.”

Sure they do… until they don’t.

People who steadfastly held onto their stock portfolio from peak (10/9/07 DJIA at 14,164) to most recent trough (3/9/09 DJIA at 6,547) saw almost 54% of their portfolio vanish.

In just 17 months, over 12 YEARS of DJIA gain disappeared. (DJIA closed at 6528 on 11/26/96.)

Buy-and-hold investors would need to see a gain of more than 116% to bring their portfolio back to the 10/9/07 DJIA peak (14,164) from the latest DJIA valley (6,547).

Of course, those who diversified among various asset classes and markets will come up with different numbers, but this is a global recession. Diversification helps very little when everything is falling. There have been very few places to hide, much less make a profit.

It really bothered me to hear financial advisers and personal finance bloggers recommend people stay the course and hold onto their stocks — and even buy more — as prices were falling. While real estate and the markets generally do rise over the long term, that is not much consolation if your retirement is near. Buy-and-hold investing has put those who are retired, or are close to retirement, in a huge pickle because they don’t have time on their side to recoup such giant losses.

I’m lucky that I don’t buy into the buy-and-hold hype. I used to, though, and I paid the price. Remember, no one, not even your investment adviser, cares as much about your money than YOU do.

During the first six months of 2008, I incrementally moved most of our stock portfolio to the safety of FDIC-insured cash accounts, limiting our losses to less than half as much as the buy-and-hold-ers have suffered. I follow momentum trends in the market, and as the trends were heading downwards, I got out and headed for safety. Buy-and-hold investors use a passive strategy;  I limit my losses by actively and systematically managing our portfolio. I invest to make money, not to sit back and watch as it all disappears.

Before the Great Recession, I was able to profit by keeping my portfolio 100% invested. This has been the first time I’ve ever held cash in our long-term portfolio. Up until this Great Recession, there were always some sectors and markets trending upwards, even as others were tanking. Momentum trend investing kept my money working for me, moving to the new market leaders as they emerged.

The investing strategy I use assigns a score to no-load mutual funds based on their 1, 3, 6 and 12 month returns. I will remain parked in cash until markets show consistent upward momentum trends, triggering the scoring system to indicate positive numbers again. Then I will move my cash incrementally and systematically into equities.

If you’ve made it this far into my article, kudos! I know that investing jargon can be hard to wrap your head around. To help explain — and review — how I choose to invest, in a fun, story kind of way, please read a reprint of an article I wrote on my old blog in March 2008, when I was in the process of moving out of equities and into cash:

How I Make Money Following the Herd: The Trend is My Friend

sheep-dog-herding

(photo by p.joran)

A couple of days ago (Ed: this would have been in March 2008), I ranted about the financial herd behavior that created the unsustainable housing market bubble. But today, I have a confession to make that might make me sound like a hypocrite. Allow me to explain by way of comparison with one of my previous hobbies.

When we lived on a small hobby farm, I participated in stock-dog herding trials. Did you ever see the movie, Babe? Yep, me and my faithful Border Collie moved a flock of sheep across fields, around fences, and into small pens. We often competed in shows to demonstrate our skill and teamwork.

As long as my dog and I kept the flock of sheep moving together as one unit, we could herd them anywhere. Their desire to stay together was intense. Though we never tried it, of course, we probably could have moved them straight off the edge of a cliff — as long as the flock did it together.

The investment strategy that I’ve been using for the last several years involves following the same “herd” that often drives me nuts. Yep, I purposely join the very same herd that creates unsustainable and irrational market bubbles.

But here’s the critical difference — I bail out of the herd when they start flinging themselves off the cliff.

At first glance, this might sound like market timing. And we know how difficult it is to time the market successfully. I don’t have the time nor desire to be a day-trader, either. So what is the difference between market timing and the investment strategy I use?

Market timing is the strategy of making buy or sell decisions of financial assets (often stocks) by attempting to predict future market price movements.”

So I’m not a market-timer because I don’t aim to forecast the market. I look at what the market is doing, not what the market might do. I enter the market after a trend properly establishes itself. I jump on the trend and ride with it. (Baa… Baa… Baa!) If there is a persistent turn contrary to the trend, I follow a mathematical signal and exit that trend.

I’ll explain this by returning back to my sheep herding analogy:

I join the already formed flock after it’s developed direction and momentum. I follow the flock as it heads towards greener pastures. I watch the front of the flock. If the leaders of the flock start to stampede off a cliff, I bail out and take a different direction. I look for another forward-moving flock to follow.

I don’t think momentum investing is in vogue with the majority of individual investors. If I had to guess what is most popular, I’d say it’s the passive strategy of buy-and-hold index investing. I am a previous buy-and-hold index fund investor myself. There is nothing “wrong” with this strategy. After all, the long-term trend (note the word “trend” again) of holding the total market is up. A buy-and-hold-index portfolio is easy to manage, enjoys low expenses, and often saves on taxes.

Every trader needs a trend to make money. If you think about it, no matter what the technique, if there is not a trend after you buy, then you will not be able to sell at higher prices…”Following” is the next part of the term. We use this word because trend followers always wait for the trend to shift first, then “follow” it.

Van K. Tharp, author of Trade Your Way to Financial Freedom

Momentum investing is different than buy-and-hold because it exploits investor herding behavior. As a previous shepherd, I intuitively understand this concept. Rather than buy-and-hold the total market through all of its peaks and valleys, I baa-baa-baa my way to the bank.

The ultimate goal of investing is often touted as buy low and sell high. Some would argue that today’s market provides an excellent time to buy while share prices are comparatively low; and that selling now could be locking in losses.

Conversely, by following a momentum strategy, I aim to buy as shares move up and sell them when even higher.

Richard Driehaus, the founder of Driehaus Capital Management, Inc., is widely considered the father of momentum investing. This Chicago money manager takes exception with the old stock market adage of buying low and selling high. According to him, “far more money is made buying high and selling at even higher prices.

Momentum investing, Wikipedia

Richard Farleigh, author of Taming the Lion, showed that markets continued in an existing direction around 55% of the time and reversed themselves the other 45%.

Similarly, Dal Company (NoLoad FundX) states that “Upgrading outperforms the market, as measured by the S&P 500, only about 55% of the time when measured on a monthly basis. But we end up far ahead in the long run because when we outperform, we do so by a larger measure than when we underperform.”

Now that might not sound like much, but for an investor 10pc represents a massive advantage. If you get 55pc of your calls right and manage your portfolio properly by riding winners and cutting losers you will make a lot of money.

So what does this mean for the investor? First, it argues against contrarian investing, which says you should look for opportunities where the market has overshot one way or the other. If prices move with the trend more than half the time, you start your search with an immediate handicap.

…stick with your winners. Trends go on for a lot longer than you might expect.

Tom Stevenson, Telegraph Media Group Limited

In other words, momentum investing entails buying winners and selling losers!

dogs-herding-sheep

(photo by ianlord)

What does the “flock” indicate about today’s market conditions? How am I responding with my own investment portfolio?

In sheep herding terms: When a Border Collie puts too much pressure on the flock by moving too quickly or too erratically, the flock panics and sheep scatter everywhere. Sometimes individual sheep get hurt in the mayhem.

Investing: Wall Street shows the market swinging wildly up one day, wildly down the next, back and forth. Investors are feeling too much pressure. Panic is prevalent and money is scattering here, there and everywhere.

In sheep herding terms: When sheep scatter, the shepherd instructs the dog to stop dead in their tracks for a moment to allow the sheep to get over their panic and drift together to form an orderly flock once again.

Investing: Market trends have all but disappeared at the moment and little seems to “stick”. By halting my investing temporarily, I’m waiting for investors to stop their panicked scatter, calm down, and form identifiable trends once again.

In sheep herding terms: When the flock is calm and moving together again, the shepherd instructs the dog to get up and move forward.

Investing: When investors and the market have calmed down, stabilized, and show cohesive movement in identifiable sectors, I will resume my momentum investing by following the new market leaders.

How do I control risk?

I’m diversified. I invest in mutual funds and ETFs. I limit any one mutual fund or ETF holding to a maximum of 10% each (5% max. in more speculative sectors).

I’m systematic. I have predetermined entry and exit marks that help to keep me from reacting emotionally. I limit my upgrading to once or twice per month.

I cut my losses. During periods of high market volatility, I reduce my exposure to the market by cutting back on my positions. My objective is to preserve capital until more positive price trends reappear.

Disclaimer: My investment strategy and portfolio allocations are not right for everyone and should not be construed as advice. If you’re not sure how much risk to take, or whether your investments accurately reflect your life goals or appropriate timeframe, get some individualized help. Many 401(k) providers have investment professionals available to talk to participants about their allocations. Or consider talking with a fee-only financial planner. You can find one online at the web site of the National Association of Personal Financial Advisors, or the Garrett Planning Network, a group of advisors who charge by the hour.

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