In Defense Of Playing Defense (Part 2)

by: Erik Conley

Part 2: The Downside Of Buy & Hold

In part 1 of this series, I posed the following question:

What would you do if you found out that your entire approach to investing was wrong? I said that this happens more often than you might think, and for a good reason. The investment advice industry, and the major financial media outlets, work hard to create the impression that the Buy & Hold method is far superior to any other approach that an investor can choose. But is this true?

This series will definitively, unequivocally, and finally reveal the answer to this question. (O.K. maybe I'm overstating the case just a little, but this is something that I'm passionate about.)

In this installment of this series, I will focus on the downside of using the B-H approach. My view is that as long as the investor is aware of both the upside and the downside, he or she will be in a position to make an informed decision. That may end up being B-H, but at least it will be a rational choice based on the evidence - not just the hype.

Here are some of the downsides I'll be addressing today:

  • For most of us, B-H is not the "natural" way to manage our money. It's sold to us as the "smart way" to invest.
  • B-H requires sitting back and doing nothing while your life savings are ravaged by large market declines.
  • Markets go through long stretches (20+ years) where investors earn little or nothing.
  • On a practical level, most of us think in terms of what the future might look like in 5 or 10 years, not 20 or 30.
  • The most harmful aspect of B-H is the loss of time. If you lose 5 years, you will never get that time back.
  • The real measure of the effectiveness of any strategy is how quickly and safely it gets you to your objectives.

The Importance of Time

For investors, money is just a means to an end. Specifically, it's the accumulated purchasing power afforded to you as an investor. Here's a practical way to frame this idea: given the choice of one approach that is easy to manage, but requires accepting long stretches of time where there is little or no forward progress, and another approach that shortens the amount of time it takes to reach your final objectives, which has more appeal to you?

Let's be honest. Some of us are just too busy with living our lives to care about the finer points of choosing an investment strategy. Some of us are just not interested in the minutia of investing strategy. Still others are just not up to the task of investigating, analyzing, and selecting the optimal choice for our circumstances.

These are all legitimate reasons to go with B-H. But some of us are willing and able to go the extra mile and compare the pros and cons of various approaches in an effort to do better than settling for B-H.

Let's turn our attention to the concept of time as it relates to choosing an investment strategy.

​"Time is the one resource that can never be renewed. Once it's gone you can never get it back."

The Loss of Time with B-H

This elegant chart from Jill Mislinski and Doug Short at AdvisorPerspectives says it all. In their article, they call this chart the "Return Roller-Coaster." It shows the returns a B-H investor would get over rolling 5-year periods in the market. (They use real total returns, including dividends, and adjusted for inflation. This is what investors will actually earn in terms of purchasing power over these 5-year periods.)

Depending on which starting point you use, your 5-year returns will vary from a high of 33% per year, to a low of minus 13% per year. This raises an important question - what would you do if you were a B-H investor and you watched as your account value declined by 13% per year for 5 years in a row?

It's my opinion that very few B-H investors would tolerate that kind of punishment. Most of them would reach a breaking point and begin to sell off their portfolio holdings. Their life savings are getting trashed, and it's human nature to do something to protect it from getting any worse.

Everybody is a Buy & Hold investor until their account value starts going down.

As I said earlier, B-H is not a natural way to approach investing, and the chart above shows why. I'm sure that some of you have the guts to ride things out, but you're the exception that proves my point. You're in the minority.

Now let's expand the time frame to 10 years and see what B-H investors must endure.

The story is the same at a 10-year time frame, but it's really worse. Where the B-H investor may have had the intestinal fortitude to ride out a 5-year negative rate of return, would he or she have the stamina to endure a 10-year period of negative annual returns?

I'm sure they're out there, but they are as rare as a bald eagle. Consider the B-H investor who began his journey in 1999. This poor soul had to suffer through two major bear markets and see his life savings decline in value by nearly 6% per year over the next 10 years. That's not easy to do, and it certainly is not natural.

What's the Solution?

The solution is to play smart defense. What's that? My version is having a rules-based Plan B that is designed with one purpose in mind - shortening the amount of unproductive time that is wasted with a B-H approach.

I will begin to address this in the next installment of this series. Until then, take stock of the approach you are using now, and ask yourself if you are open to the possibility that there may be a way to stick with your current strategy during bull markets, and shift to a more defensive stance when conditions call for it.