Have you read the financial obituaries announcing the demise of long-term buy and hold methodology?
Have you heard that diversification no longer protects investors?
The soothsayers tell us the rules of investing have changed forever. They foretell a future devoid of modern portfolio theory. The “new rules” embrace stock picking, market timing and behavioral analysis. Anyone who patiently invests for the long-run is naïve.
One of my clients recently asked me point blank if things had changed, if her portfolio was out of touch with the new realities of our current market.
Are you asking the same questions?
Here is what I told my client:
1) The “buy and hold” strategy most often discussed these days is vastly different from the way you invest with us. The typical buy and hold argument is to buy a “good” company stock and hold it forever. This has always been a very risky strategy since there is truly no way to identify a “good” company for the long-run. Every company and every business sector has individual risks that could severely hurt, if not devastate, your portfolio. An executive could embezzle away company funds. A product could fail. A lawsuit could devastate an industry. Innovation could leapfrog past current market leaders. Buying and holding Lehman Brothers, Freddie Mac, Fannie Mae, Bear Stearns and Washington Mutual, not to mention previous losers like Enron, WorldCom or Global Crossings did not work out too well for any investor.
Your portfolio is a long-term asset allocation strategy that buys and rebalances in keeping with your risk and reward profile. Stocks in the building-block funds may move in or out of the asset class and are sold or bought accordingly. You minimize individual stock or sector risk through broad diversification. We may pursue tax harvesting within the account when it makes sense. Yes, you are buying for the long-term rather than timing the market or chasing yesterday’s hot sectors. But you are also investing in keeping with your risk tolerance and eliminating the speculative behaviors that have historically sabotaged returns rather than enhance them.
2) Investors must accept the short-term risks of equity markets in order to embrace the potential for long-term rewards. Eliminating risk would eliminate the potential for long-term reward. No one would invest in risky assets if they had no opportunity for reward over the long-run. Unfortunately, we are wired to forget the risks and overestimate our risk tolerance when markets are up and dwell on the risks and amplify our worries beyond what the historical evidence teaches when markets are down. Up markets have been followed by down markets many times in the past and they always result in someone declaring the market dead.
Conversely, down markets have always been followed by up markets. There is no reason to believe this has changed even though things are tough on a global scale. The bursting of the internet bubble was painful. The bursting of the credit bubble has been equally, if not more so, painful. The fact both occurred so close to one another adds to a sense of pain and worry the markets are broken.
Fortunately, history offers us reliable perspective. The S&P 500’s worst 12-month return was -67.57% from July 1931 – June 1932. Guess when the best 12-month return occurred? From July 1932 – June 1933 the S&P 500 rallied up 162.88%. The same pattern holds for the best and worst 3-year annualized returns. The S&P 500 was down -42.35% annually from July 1929 to June 1932. The S&P 500’s best 3-year annualized return was 43.35% per year from March 1933 to February 1936. The same pattern continues for the best and worst 5-year annualized returns. The S&P 500 took an annualized -17.36% hit from September 1929 to August 1934. The market’s incredible annualized 36.12% recovery from June 1932 to May 1937 was the S&P 500’s best 5-year annualized period since the index began.
We do not know what comes next or how long it may take for a recovery to begin. Investors have historically been rewarded for patiently waiting and remaining exposed to market risk. While you may hear a lot of gloom and doom (and we always have in previous downturns) there is no good reason to believe things have changed. The good news is recovery has always followed decline and I put my faith in history eventually repeating itself.
3) You’ve already absorbed the risk to this point, so it only makes sense to wait things out and be there for all the reward the market may offer.
My advice to her is the same as my advice to you. The rules have not changed. A globally diversified, low-cost, asset class based portfolio built for the long-term remains the best way to maximize your potential for long-term reward and minimize your concerns about this painful bear market.
Allow me to borrow from the wit and wisdom of the great Mark Twain. The reports of the death of Peaceful Wealth are greatly exaggerated.