It Is a Logical Impossibility That Buy-and-Hold Could Ever Offer Good Risk-Adjusted Results
The difference between Buy-and-Hold and Valuation-Informed Indexing is that Buy-and-Holders stick with the same stock allocation at all times while Valuation-Informed Indexers go with higher stock allocations when stock valuations are low and lower stock allocations when stock valuations are high. That means that Valuation-Informed Indexers practice market timing, of course. Buy-and-Holders see that as a dangerous practice. They find it hard to believe that adding the riskiness of market timing to the stock investing mix could ever produce a good result.
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Buy-and-Hold Offers Better Results In The Short Term
They couldn’t be more wrong (in my assessment). It is abstaining from market timing that is the more risky behavior. It is certainly true that Buy-and-Hold can offer better results in the short term. But in the long term the strategy that calls for market timing is always going to produce better risk-adjusted results. It is a logical impossibility that that would ever not be the case.
Mohnish Pabrai: “From Ben Graham to Phil Fisher”
In the middle of April, value investor Mohnish Pabrai the Managing Partner at Pabrai Investment Funds presented the topic “From Ben Graham to Phil Fisher” at the Ben Graham Centre for Value Investing’s 2021 Virtual Value Investing Conference. Q1 2021 hedge fund letters, conferences and more Deep value Pabrai started his career as a deep Read More
To understand why this is so, you need to consider why it is that the idea that market timing is a bad idea ever caught on in the first place. Market timing has always worked. That’s been so for 150 years, which is as far back as we have good records of stock prices. The tricky part is that market timing often produced poor results over time-periods of one or three or five years. It is only in the long term that the magic of market timing evidences itself. In the end, it always pays off.
The magic is conveyed in a term that Buy-and-Holders use frequently — Stay the Course! What the Buy-and-Holders intend to signify by the phrase is that investors should stick with their plan no matter what. To the Buy-and-Hold mind, that means not changing your stock allocation in response to shifts in market valuations. Stick with the same stock allocation at all times and you will have your ups and downs but in the end you will earn the market return, which should be more than enough to make you happy.
The flaw in this argument is that the market is not the same thing at times of wildly different valuations. When prices are super low, the most likely 10-year annualized return is 15 percent real. When prices are super high, the most likely 10-year annualized return is a negative 1 percent real. There is no one stock allocation that makes sense in both sorts of circumstances. So an investor who follows a Buy-and-Hold strategy is certain to be going with a less-than-ideal stock allocation much of the time, perhaps most of the time.
Valuations Affect Long-Term Returns
The Buy-and-Holders made the mistake because we had limited research available to us at the time they developed their strategy. At that time, there was a widespread academic belief that the market is efficient (that is, that investors act rationally in pursuit of their self-interest). Shiller discredited this idea when he showed with peer-reviewed research that valuations affect long-term returns. If that is so, stock investment risk is not stable but variable. Stocks are more risky when valuations are high. So the investor seeking to keep his risk profile constant over time must be willing to engage in market timing to have any hope whatsoever of being able to achieve that goal.
It is not the investor who sticks with the same stock allocation at all times who is staying the course in a meaningful way, it is the investor who engages in market timing. To stay the course, an investor needs to keep his risk profile stable. In a world in which risk changes over time, it is the market timer who does that.
The peer-reviewed research that I co-authored with Wade Pfau shows that market timers usually earn higher returns in the long run. Their returns often lag the returns earned by their Buy-and-Hold friends for time-periods of five years and ten-years. But at the end of 30-year time-periods, the Valuation-Informed Indexer usually finds himself with a much larger portfolio.
Is that always so?
Not if you go by nominal returns. The market timer lowers his stock allocation when prices reach sky-high levels. There is a price attached to doing that. The money removed from the stock market until sanity reasserts itself is placed in safe investment classes like certificates of deposit and IBonds, which usually offer much lower returns. That’s not a big deal so long as stock prices drop hard within ten years or so. The reward for missing out on a price crash is great enough to cancel out the effect of investing a portion of one’s assets in a lower-return asset class.
Rare Cases For Stock Returns
But there are rare circumstances in which stock returns remain super high for a longer time-period than that. We are living through such circumstances today. With the exception of a few months immediately following the 2008 crash, stock prices have been super high for 25 years. Going with a lower-return asset class is going to hurt an investor’s lifetime return, even if stock prices ultimately return to fair-value levels.
So Buy-and-Hold sometimes prevails. Right?
I wouldn’t put it that way. In rare circumstances, Buy-and-Hold can provide better nominal returns. But it is important to remember that the investor does not know at the time that he makes his decision to stick with his high stock allocation despite the crazy valuation levels that apply at the time that this is going to be one of those exceptional cases in which the no-market-timing strategy happens to pay off. The odds of Buy-and-Hold generating better long-term results than market timing are about one in ten. The investor who fails to practice market timing is essentially gambling his retirement money on a bet that has a one-in-ten chance of paying off.
The proper way to compare the two strategies is on a risk-adjusted basis. On a risk-adjusted basis, engaging in market timing is always the better choice. There can be reasonable differences of opinion as to how often an investor should engage in market timing and as to the extent to which he should adjust his stock allocation when he does so. But it is a logical impossibility that the investor could ever have high confidence that adopting a strategy that disdains market timing could work in the long term. It has been a rare event for that sort of scenario to play out in the 159 years of stock market history for which we have good records.
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