March 28, 2013
Many market pundits recommend Buy and Hold strategy for stock investor and MPT proponents make investor life even more easy saying that you need Buy and Hold a wide index like S&P500. There are 2 factors that rule a typical stock index (like S&P500, Dow-Jones 30 and many others)- natural life of firms (merger, bankruptcy, etc...) and human judgment (hidden committee selects firms for S&P500 index).
An investor can agree or disagree with the second factor but in most cases has to accept the first factor (well if investor is powerful insider /s/he can resist a merger).
So how good "Buy and Forget" approach was for investors in the past?
On the first glance (see graph below) it works good for equity markets in many countries:
But for stock investor results are not so nice: Shocking numbers come form Jeeman Jung and Robert J. Shiller paper "Samuelson's Dictum and the Stock Market" (2005):
"In fact, when we did a search on the Center for Research on Security Prices (NASDAQ:CRSP) tape, we found that there were only 49 firms that appear on the tape continuously without missing information during the period of 1926 to 2001." They also note "When Poterba and Summers (1988) did a similar search of the CRSP tape, they found 82 survival firms during the 1926-85 period. The smaller number here apparently reflects the continuing disappearance of firms through time."
Well, I can presume that CRSP tape is not perfect prior 1985 even knowing that this is one of the best stocks historical database, but I cannot imagine that any data is missing in CRSP for 1985-2001 period. So from 82 survival firms at 1985 (which are probably well-established companies) only 49 firms appeared in 2001. Hence formally losses for "Buy and Forget" investor who bought 82 survival firms at 1985 are about 40%. I know from Dividend Heritage Project (seekingalpha.com/instablog/725729-sds-se...) that the reason for about 50% of firms disqualified for good dividend mark (i.e. has steady or DG payments) is merger. Probably this half-and-half ratio is applicable to Jung and Shiller (2005) vs. Poterba and Summers (1988) studies. In this case real losses for 1985 "Buy and Forget" investor should be about 20%. Just to remind - I am talking about the respectable surviving firms with 60+ years history of doing business here. This 20% of loss of position in stock portfolio in 16 years during the best time in history of US stock market (1985-2001) is terrible in my opinion.
On another hand most of academic studies of stock market explore idea of periodical rebalance of portfolio. I understand that this mechanical process is important for a scholar study because active management will lead to strong difficulties in comparison of various studies. Academics (should) know that real effect of rebalancing is close to nothing or sometimes negative (see graph below /I guess from Lussier studies/)
I understand that financial service providers vote for rebalancing because it creates money for them (fees, transaction cost, etc...). What I do not understand why individual investors follows such pundits recommendations (probably because they do not aware on real results shown in graph above). Common argument is "this stock is overvalued" based on price/fundamentals. I think it is too naive (at least for large caps) to assume that it can be true and each investor must remember simple relation:
Market Price (known) = True Fundamental Value (unknown) + Mispricing (unknown)
As old adage says "People know price of everything and value of nothing"..... There are rarely periods (Jan 2000 for NASDAQ, March 2009 for US market) when abs(Mispricing) is probably much large than True Fundamental Value, ......but who knows the future which affects to True Fundamental Value? IMO in such moments investor might take a risk and rebalance (I'd rather say re-allocate) his/her capital.
Therefore I prefer "Buy and Monitor" strategy and a dividend investor IMO can monitor portfolio on annual basis but not rebalance it for the sake of rebalance.