Tuesday, September 18, 2012

The Best Way to Grow And Preserve Wealth?

“Buy and hold is dead!” critics claim.
Once believed to be the best way for investors to accumulate wealth over the long term, “buy and hold” portfolios took a pounding in the recent bear market. The cries came out loud and clear that the old truth was wrong and "buy and hold" as an investment strategy was dead. 

Let's take a closer look at just what buy and hold means, as it pertains to investing.

What is buy-and-hold, anyway?
Buy and hold in and of itself doesn't tell us much. Buy-and-hold what? An individual stock, a group of stocks, an index of stocks or bonds?

Or does it mean you "set it and forget it" – just buy what looks good and hold on for dear life?

And what about having a plan or managing risk? The original message and intent of "buy and hold" was to select quality investments and invest for the long term. But this is easier said than done. People are by their nature emotional when it comes to money and investing. They tend to do what everyone else is doing, hence, they buy as stocks peak and sell when they hit bottom. The buy and hold maxim helps us counter our emotional tendencies to take the wrong action at the wrong time.

You might suggest, as do critics of buy and hold, that it would be better to protect ourselves from protracted periods of stock declines by timing entry and exit into stocks. Great in theory, but available data suggests that you cannot time the market and be right often enough to make this a profitable approach. Not only do you have to be right about when to get out of stocks, but then also about when to get back in.

Buy and hold reminds us not to time the market and to stay invested for the long term.

What’s missing?
Noticeably absent from the buy-and-hold approach is any mention of a plan or risk management. While many people get into stocks because they think they “should” ~ and consequently give little thought to managing risk ~ most people invest in the market as part of an overall financial plan, which takes into account their tolerance for buying more risky investments.

As to the hold portion of the strategy, hold until when? This is clearly not meant to suggest we hold on no matter what. Review and rebalance are the missing pieces of the recipe. Initially, an investment is made to fill a specific role or purpose in the portfolio. Once the reason for holding it plays out, it makes sense to sell.

Circumstances change. As people age and accumulate assets they may no longer want to assume as much risk. As life changes occur the original asset allocation will need to be changed. Again, the annual review will bring these types of issues to light so action can be taken as needed.

When we allocate assets and diversify to manage risk, we establish asset allocation targets. These are the percentages you have invested in each major category of investments, such as stocks, bonds, real estate and cash, etc. Over time these will drift from their targets. Rebalancing restores the portfolio to its best fit for attaining one's objectives. For instance if stocks grow over time to become 75% of the portfolio and your target is 65%, you would sell stocks to get back to your original target. You are selling something that has done well to put money into things that have greater potential for appreciation. This is a discipline of selling high and buying low, just what we all aspire to do when it comes to investing.

As we look closely at "buy and hold" it seems less a specific strategy and more a small piece of a much larger process. This method, or philosophy of investing as articulated here, acts to bring discipline and rationality to a process where we know that our emotions get in the way of sound reasoning. It starts with planning, saving and managing risk. It involves allocation of your investments to meet goals. Buy and hold helps remind us that we have a plan and are investing for the long haul. Reviewing and rebalancing complete the process.

Beauty in simplicity
I will close with a quote from John Prestbo in the  Journal of Indexes (January/February 2010.) Its beauty lies in its simplicity.

"It is possible to reduce the whole investment process to a series of three-word maxims:
 

Make your plan. Keep on saving. Allocate your assets. Buy and hold. Review every year. Rebalance if needed."

This is the best way to grow and preserve wealth!

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