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This is part of the series where we explore the myths in popular investing as exposed in Michael Dever’s new book, “Jackass Investing.” In the book, Dever uses experience from three decades of hedge fund management to explore how the conventional wisdom in investing and portfolio management preaches little more than gambling.

By Joseph Hogue, CFA

Chapter two in the book really defines the concept of the work. The chapter goes after the end-all, beat-all myth in individual investment theory; that buy-and-hold is the only strategy you need and the only one you should follow. I’ve always had a problem with the theory, if not for its seemingly over-simplistic method, simply for the fact that it is preached with such religious-like fervor.

Buy-and-hold is the one true strategy and thou shall have no other strategies before it. I think the religion analogy is particularly appropriate because buy-and-hold investors are putting their unwavering faith that, at the end of their investment horizon, these stocks will provide for them.

Imagine trying to forecast which companies will still be around, let alone will perform well, in the next thirty or so years. For this reason, and admittedly to be a little mean, the strategy will be referred to as buy-and-pray for the rest of the article. Proponents of buy-and-pray use analyst and portfolio manager results against the long-term performance of the market as a way to ‘prove’ that the strategy outperforms a dynamic approach. There are a few problems with this reasoning used to justify buy-and-pray.

Market Efficiency in the Absence of Active Management

Proponents love to quote studies where no analyst or manager has beaten their index consistently after fees for a long period of time, implying that the market is so efficient that no one is adept enough to outperform over the long-term. The problem here is with the counterfactual, or the result of the study in the absence of the managers.

In the complete, or near complete absence of active management, the market would cease to be as efficient as it is now. The very competition by active managers and analysts is the driver behind market efficiency. Take this competitive environment away and the market would cease to be as efficient. A true investment strategy should work in the counterfactual as well.

The performance of the buy-and-pray strategy is extremely dependent on the length of time and the specific dates in which the investor begins and ends the strategy. This won’t be much of a surprise to those whose investment funding period started around the year 2000. Even with dividends reinvested, the buy-and-pray approach has performed horribly over the last 11 years and the younger cohort of investors is not alone.

The chart below, copied from the book, shows the growth of $100 invested in a basket of U.S. stocks in 1900 without dividend reinvestment. The chart is overlaid with the market P/E ratio because we’ll be using that information within our action strategy at the end of the article. You can see from the chart that the return provided by the market as a whole is dependent on investing and withdrawing at just the right time.

If you began building your nest egg in the late 60’s your annualized returns with dividend reinvestment would be a miserable 5% when you retired around the turn of the millennium. As we saw in the first article in the series, which discussed the return drivers for equities, stock returns are highly dependent on investor enthusiasm and the price investors are willing to pay for earnings.

Baseline Conditions for Buy-and-Pray

The author spends much of the chapter talking about another reason why buy-and-pray has been so touted among American investors, because it has coincidentally worked. With reinvested dividends, an investment in our basket of stocks since 1900 has returned an annualized real-rate of 6.3 percent. This isn’t great, and each investor’s actual return relies largely on the factors discussed above, but for those with no knowledge of investing or motivation to learn, it might be sufficient.

The author points out a big problem going forward. The baseline conditions have changed for our basket of American stocks. Looking at the chart above, you can see that equity appreciation really only started to take off in the mid-1950’s. In the last 55 years, we Americans have been at the forefront of global economic dominance and have the GDP growth to prove it. Our GDP in 1955 was about $415 billion and today it tops out at a hefty $14.5 trillion.

Since 1955 the United States has experienced annualized GDP growth of about 6.5% per year, but growth in the last ten years has only averaged about 3.8%. The impressive growth in GDP over the last century was the baseline condition underlying buy-and-pray investing. To grow at the same pace for the next 55 years, our economy would have to be almost $500 trillion dollars in 2065. With new emerging economic powerhouses competing for global dominance, this isn’t likely to happen. A sobering reminder of this can be seen in the chart below which shows the annualized U.S. GDP growth over the last sixty-years on a trailing ten-year basis.

There are two ideas that an investor should really take away from the chapter and are really basic to the underlying themes in the book. First, for investors to create a truly diversified portfolio that will deliver on the promise to help achieve their financial goals, they must understand where the ‘conventional’ wisdom in investing is wrong.

This isn’t done by reading the ‘play-it-safe’ investment textbooks. This is done by understanding the specific influences that drive the returns for your investments. Using a buy-and-pray approach, but failing to understand that corporate earnings only play a small part in equity returns over very long periods is a recipe for portfolio loss and high volatility. Once an investor recognizes the return drivers for an investment, they can begin to better understand how to invest and how to create profitable trading strategies.

The second theme within the chapter is that investors must understand the baseline conditions under which their trading strategies will play out. Sure, investing in a basket of American stocks has worked over particular periods of time in the last 55 years, but this will not be the case going forward. The baseline condition to the strategy, that of American global economic dominance, will inevitably change going forward and investors must be ready. Changing baseline conditions is exactly the reason why investors need to incorporate several distinct strategies within their portfolio. By using several distinct strategies, each with distinct return drivers, the baseline conditions underlying one strategy can fail without the entire portfolio experiencing systemic losses.

Action Strategy

There will always be a faithful cadre of followers to the buy-and-pray approach. No amount of facts or figures will sway them from the fix-it and forget-it methodology. The strategy I’ve put together here is for those that recognize the flaws in buy-and-pray but cannot bring themselves to fully separate from the myth. The strategy utilizes a core-satellite approach which holds a fairly static core portion of stocks that is only occasionally rebalanced. The satellite portion of the portfolio is designed to provide excess returns through active management and to diversify across different strategies and return drivers.

The total core-satellite portfolio will be between 40-60% of the investor’s total investment. This will depend on your age, risk tolerance, and prevailing market prices (i.e. price-to-earnings ratio). Remember the earlier chart showing market returns and P/E? There is clearly an argument for rebalancing equity positions when market price-to-earnings deviates significantly from about 15 times earnings.

This rebalancing should not have to happen every year, but every few years as stocks deviate more significantly from the average ratio. The remaining portion of total investable funds will be used in non-equity investments like commodities, bonds, managed futures, and real estate. The second article in this series took a hard look at investors’ fear of commodities and developed a simple currency trade. Within the 70% core portion, we will place equal amounts into funds that invest in equities across four regions.

The iShares Dow Jones Select Dividend Index Fund (DVY) holds 100 U.S.-based stocks well-diversified over investment styles. This fund is for those investors that just cannot seem to give up on U.S. companies while realizing that economic growth going forward will drive global returns. The fund provides a dividend yield of 3.8% and only charges a 0.4% expense fee. Using this strategy still exposes 7.0-10.5% of the investor’s total investable funds to the U.S. market, 40-60% in equities and 25% of the 70% core in U.S. based companies, but puts it in dividend paying investments.

The iShares S&P Latin America 40 Index Fund (ILF) is heavily weighted to Brazil and Mexico, but also gives the investor exposure to Chile, Peru, and Colombia. Having lived in Colombia and recently spoken at a Bloomberg conference on market integration, I am very positive on the region’s growth prospects over the long-term. The current market volatility related to problems in Europe provides a more reasonable entry point into LatAm equities than earlier this year.

The WisdomTree Middle East Dividend Fund (GULF) tracks the company’s own Middle East dividend index. Though problems associated with food and water shortages may continue to spark unrest within the region, the markets have generally rebounded quickly from the Arab Spring uprisings this year. The fund’s country exposures are fairly diverse with Qatar (33.8%), Kuwait (28.2%), U.A.E. (19.0%), Morocco (11.7%), and Oman (5.5%). The fund pays a dividend yield of 5.75% and includes an explicit goal of dividend payments within its mandate.

The SPDR S&P Emerging Asia Pacific ETF (GMF) holds 264 mostly large-cap companies across the region. Though the fund is heavily weighted toward China (43.4%), it also provides exposure to India (17.5%), Taiwan (17.0%), Malaysia (9.4%), and Thailand (5.2%). The fund pays a dividend yield of 1.9% and charges 0.6% in expenses. Though the fund has not performed well over the last year, with a loss of 18.2%, the region will be a leader in global economic growth in the years to come and investors should have some exposure.

The remaining 30% of the investment in equities is used for trading strategies with various return drivers. Though each of the funds below will be driven by economic growth within their respective regions, they will also be influenced by overall global growth and investor enthusiasm. Using different equity strategies within the satellite portfolio will help diversify returns for the overall equity portfolio. We’ll cover some possible strategies in other articles within the series. One possible strategy, short-selling, was detailed in last Friday’s article. Short-selling stocks can significantly enhance returns and there are actually a few market characteristics that favor short-sellers and small investors.

If buy-and-hold is not a religion, it is certainly a lottery ticket. You invest your money and hope that when you go to retire, the market will be up and investors will be paying dearly for earnings. Granted, I like to gamble. I’ll play a little craps or blackjack every few months and have a good time, win or lose. Despite this, I am not willing to gamble with my life’s savings. The baseline conditions for the buy-and-hold strategy have changed and investors must adapt to meet these new conditions.

Source: A Semi-Active Strategy To Beat Buy-And-Hold