Is buy-and-hold dead and gone?
Investor Daily: As volatile and scary as stocks look now, here are three big reasons not to abandon your investing strategy.
(Fortune magazine) -- That's about the craziest thing I've ever heard!" shouts Jeremy Siegel through the phone when I mention the headline of this story. "I mean, what's the rationale for anyone saying that?" I had called up the Wharton professor because he's one of the high priests of buy-and-hold investing. In his classic book, Stocks for the Long Run, Siegel analyzed 200 years' worth of U.S. market returns and concluded that patient, consistent investment in stocks over a long period is the most effective strategy for wealth creation among regular folks.
It's a message that makes a lot of sense to people under normal circumstances. But lately, of course, the market has been anything but normal.
As Siegel and I were speaking in mid-October, the Dow was down some 39% from its high a year earlier. Investors were taking their money out of equities by the billions. The S&P 500's ten-year return was -11% (with dividends included, it was up a measly 5%). Plenty of people had suddenly begun to ask themselves whether the idea of long-term investing was a sham.
Interviewed on thestreet.com TV, CNBC's Jim Cramer declared, "You haven't made any money in ten years, so buy-and-hold must come into question." Siegel begs to differ. "We had a bad ten years, so now we're going to have another bad ten years?" he wonders incredulously, sounding as if he wants to reach through the receiver and rap my knuckles. "I'm overwhelmed by the emptiness of that idea. The history of the market is precisely the opposite. If you have a bad ten years, you're likely to have a good next ten years."
That may be, but it's hard to look at your retirement savings in such a rational way when a bear market is raging - and this one is a hulking, rabid grizzly. The widely accepted definition of a bear market is when stocks fall 20% or more from their high. We got there back on July 7, when the S&P 500 closed at 1,252. Doesn't that seem like a happy, innocent time, compared with recent lows? The market has now fallen more than 40% from its high - just the third time that's happened in the past 50 years. No wonder it feels a little bit like the world is ending.
Making matters worse, U.S. equities are hardly the only investments that have been routed. "What we have right now is a take-no-prisoners market," says Robert Arnott, who manages more than $35 billion as founder and chairman of investment firm Research Affiliates in Pasadena. Arnott says that of the 16 different asset classes he and his team track, every single one except U.S. Treasuries was down in September. That was the first month in three decades that 15 out of 16 categories were down at the same time. And things only got worse in October. "This is definitely the ugliest asset-allocation market we've seen in the last 30 years," says Arnott. "So we're looking at markets without a lot of precedent."
That's what happens when you have a near-total meltdown of the world financial system. And though the infusion of trillions of dollars of stimulus by governments around the globe has apparently begun to calm the credit markets a little, there may still be plenty of bad news to come. Today the question on the minds of most economists is not if a recession is happening, but how painful it will be. In late October, Fed chairman Ben Bernanke warned of a "protracted slowdown." In this kind of environment, it's only natural to question whether the strategy you're following makes sense. You may, in fact, feel that riding the market's highs and lows isn't for you at all.
"What I always try to tell every client I talk to," says value-oriented mutual fund manager Wally Weitz, whose Omaha-based Weitz Funds oversees some $3 billion, "is that if you're going to have a stock portfolio, if you can't stand either financially or emotionally to have it be down 50% at some point, you shouldn't be in the stock market." But if you can pass the Weitz test, being a buy-and-hold investor today makes as much sense as it ever did. The point of sticking to sound, fundamental strategies, after all, is to keep you from making big mistakes in moments of crisis. And abandoning the market now could turn out to be a very big mistake. Here are three reasons.
We've got proof. If you get out now, when will you get back in? "You really have no choice but to stay the course in an intelligent way," says John Bogle, who as founder of Vanguard has been one of the great pioneers of low-fee mutual funds as a vehicle for buy-and-hold investing. "It's one thing to get out of the market at the perfect time - how many people can do that? - and quite another to get back in at the perfect time. You've got to be right twice."
The evidence shows that most investors get it wrong over and over again. According to a study called the Quantitative Analysis of Investor Behavior by financial research firm Dalbar, over 20 years through the end of 2007, the average equity-fund investor earned an annualized return of just 4.5%, vs. the S&P 500's 11.8% return. Why? In large part because investors, chasing performance, shift money out of lagging funds and into hot ones at the wrong times. We buy high and sell low repeatedly.
Need more evidence? Go back to the dot-com bubble. In the first quarter of 2000, according to Morningstar, investors channeled $97 billion into equity funds - nearly double the total of the previous two quarters - right before the S&P 500 peaked on March 24, 2000. And in the third quarter of 2002, they withdrew $41 billion from stock funds just before the market bottom on Oct. 9. What's happening now? Fund research firm TrimTabs reports that investors pulled some $56 billion out of mutual funds in the first ten days of October, when the market was already 25% off its high.
Rather than thrashing about like that, we would all be better off focusing on some of the simple planning rules that have been proven to make a big difference:
- Don't invest money you can't afford to lose.
- Don't let excessive fees eat into your returns.
- Do diversify your portfolio mix with fixed income and other assets, and reduce the risk in your portfolio as you get closer to retirement.
- Do consistently rebalance your portfolio.
- Do add new money steadily over time, in good markets and bad, so that you "dollar-cost average" - buying more when prices are low and less when they're high.
"The way you can make dollar-cost averaging not pay is when you get scared and stop making contributions," says Burton Malkiel, author of A Random Walk Down Wall Street and another bona fide member of the buy-and-hold intelligentsia. "This is the perfect market for it. In the long run, I think this is going to be an extraordinary opportunity for investors."
Here's all you really need to know about whether you should be in the market now: Warren Buffett is buying. As he announced in an op-ed in the New York Times on Oct. 17, he's recently begun taking advantage of the pervasive fear in the market to scoop up stocks for his own account. "If prices keep looking attractive, my non-Berkshire net worth will soon be 100% in U.S. equities," he wrote.
It's not just Buffett who's recently turned bullish. Jeremy Grantham, who oversees $120 billion as chief investment strategist at money manager GMO Capital, has been a steadfast and vocal stock bear for well over a decade. But in an October letter to investors, Grantham announced that the S&P 500 had fallen below his fair value estimate of 975 and that he would begin buying stocks (although, in keeping with his cautious approach, he warned that stocks might irrationally fall to 50% below fair value before they bottom out).
The upside of the painful bear market, of course, is that stocks are much cheaper - as cheap, in fact, as they have been in many, many years. Based on the price/earnings ratio (using earnings from the past 12 months), the U.S. market is as inexpensive today as it has been since 1990. From today's levels, says Bogle, it's reasonable to think that the S&P 500's profits could grow by 7% a year. Throw in the current dividend yield of over 3%, and Bogle believes stocks could return 10% a year for the next decade. "I don't think that's a pipe dream," he says - and this from a man who at the turn of the century was warning of years of subpar returns.
There's another reason to look past the current chaos. We may be in a recession, but the market usually comes roaring out of downturns. Earlier this year Ned Davis Research looked at the ten U.S. recessions since World War II and found that the average market return one year after the market low point was 32%. That's the kind of recovery rally you don't want to miss. "If history's a guide, we're approaching one of those rare excellent buying opportunities," says Ed Clissold, senior global analyst at Ned Davis.
As cheap as the U.S. stock market is today, there are many other markets and asset classes that have been hit even harder - and thus may represent even better deals right now. Chinese stocks, for instance, are down 68% over the past 12 months. The price of oil is down more than 50% since early July. And many emerging-market bonds have plummeted this year.
"There are some folks who've called me a perma-bear because I've been so reliably cautious on equities in recent years," says Arnott of Research Affiliates. "But this is one perma-bear who is now optimistic on a whole array of markets, including some equities. The selloff has driven yields on emerging-markets debt, on high-yield debt, on convertible bonds, on senior bank debt, and on other assets to levels that are almost without precedent. It's a pretty neat opportunity."
Arnott is also a long-term commodities bull, despite the falling prices of everything from copper to wheat. "I think what we're seeing is a commodities bear market within a long-horizon bull market," he says. "China and India are still going to grow much faster than the United States. Looking out at these emerging economies, there is still a supply-demand imbalance that favors rising commodity prices."
Mohamed El-Erian, co-CEO of bond giant Pimco, shares Arnott's view that there are historically attractive deals emerging outside of U.S. equities. The former manager of the $35 billion Harvard University endowment says global markets are experiencing a bumpy transition to a world in which the U.S. is merely one of several growth drivers - a change that he described earlier this year in his book When Markets Collide. "Every once in a while, investors have a wonderful opportunity to truly diversify at a relatively low cost, and this opportunity is coming up again," he says.
To prepare for this new world, El-Erian advises investors with long time horizons - 15 or 20 years- to have one-third of their equity investments in international stocks and another third in emerging markets. He also recommends that you protect your portfolio with inflation hedges such as Treasury inflation-protected securities (TIPS) and commodities.
And at the moment El-Erian sees some unprecedented opportunities to lock in fixed-income returns. "Three years ago, if you came to me and said, 'I need 6% returns,' I would have said you can't do that on the bond side without taking huge risks," he says. "Today you can get paid 6% on agency-backed mortgage notes. This is stuff backed by Fannie and Freddie that, as a result of the announcement six weeks ago, is now backed by the U.S. government. That's hard to beat." Hard, yes, but he expects to find even better opportunities later this year as hedge funds are forced to liquidate assets.
A few days after our initial conversation, I call Siegel back and tell him that I have come up with three reasons why buy-and-hold isn't dead. The market is even lower, but he is in good spirits. "Look, it's always painful near the bottom, but the outlook from here is extraordinary for investors," he says, echoing Malkiel. "I think the important thing is that the question of buy-and-hold comes up at the bottom of every bear market that I have gone through, and I get calls about it, and invariably that proves to be the time when you should own stocks." Let's hope history repeats itself.
Has the beating the market's taken got you wondering about how to invest now? Let us know what you'd like us to address in our next Investor Daily. E-mail Fortune.