Buy & Hold

I was recently asked how much time it takes to be a do-it-yourself investor (as opposed to using a financial advisor to manage your portfolio for you).

My reply was that it takes a considerable amount of time, which is interesting because the actual management of a do-it-yourself portfolio hardly takes any work at all:

• Rebalancing once per year is usually enough,
• Contributions (or withdrawals) can be set up to happen automatically, and
• Tax loss harvesting aside, there’s little benefit to checking your portfolio very frequently.

In other words, managing a do-it-yourself passive portfolio consists mostly of patiently, willfully doing nothing. (I’ve always liked the term “benign neglect” that John Bogle uses in his Common Sense on Mutual Funds.)

So Why Does It Take Work?

It takes work because in order to be successful over the long haul, you’ll have to educate yourself. You have to educate yourself so that you’re prepared for two challenges that will arise.

Challenge 1: At some point in time, your portfolio will perform downright miserably. (Exactly how miserably depends on whether you have an aggressive or conservative asset allocation.)

You need to be prepared for that. You need to know why you chose your portfolio in the first place, and you need to know why a period of lousy performance doesn’t necessarily mean you chose poorly.

Challenge 2: Over the course of your investing career, there will be many times when somebody (whether a broker, a financial advisor, your neighbor, an insurance agent, an author, or somebody on TV) comes along recommending a different investment strategy. And that person will have data showing that over some particular period(s), his/her strategy performed better than your own portfolio.

You need to be prepared for that too. You need to be able to spot the flaws in their arguments so that you don’t give in and swap out your entire portfolio every time someone comes along with a different suggestion.

Education is Inoculation

Educating yourself about investing works to inoculate you against both the doubts caused by periods of poor performance and the numerous alternative-strategy sales pitches you’re sure to run into over the years. The more you know, the safer you are.

February 7, 2011 9 comments

I often get questions to the effect of “I recently read about [some investment strategy]. Is that a good idea, or would it count as market timing?”

The answer, of course, is that it doesn’t matter whether or not an investment strategy “counts as market timing.” All that matters is whether or not it’s a good idea.

It seems to me that the market timing label has been applied to any strategy that has anything to do with interest rates or market valuations. And all such strategies have been declared taboo, despite the fact that there’s a huge variation as to:

1. The level of risk involved and
2. The probability of success.

To illustrate what I mean, let’s take a look at a few example strategies, any of which could be described as market timing, depending on who you ask.

Moving Between Cash and Stocks Everyday

Strategy 1: Bill moves his entire portfolio between 100% cash and 100% stocks from day to day in an attempt to catch the best days in the market and miss the worst ones.

Bill’s strategy relies on predicting what the market will do tomorrow–a feat bordering on impossible in the absence of super-human powers. And if Bill fails, he could lose a significant portion of his portfolio. This type of market timing is not a good idea.

Shifting Your Bond Maturities

Strategy 2: When real interest rates fall far below their historical averages, Larry shifts his bond allocation toward shorter maturities. Larry plans to wait until rates come back up, at which point he will switch to longer-term bonds to lock in those rates for a longer period.

Larry’s strategy is essentially a guess that interest rates will soon return to their normal range. Larry could be right, or he could be wrong. But if he’s wrong (and interest rates do not rise any time soon) the worst-case scenario is that he misses out on the slightly-higher returns that he could have gotten by holding longer-term bonds.

Moving from Stocks to Bonds (for Good)

Strategy 3: Laura is planning to retire in the near future. Her portfolio has recently grown a great deal due to a couple good years in the market. Because interest rates are currently high [obviously a hypothetical example], Laura decides to shift a significant portion of her portfolio out of stocks and into long-term TIPS (or an inflation-adjusted fixed lifetime annuity).

Laura’s strategy is based on recent market performance and current interest rates, but it doesn’t rely on any prediction at all. It’s simply a decision that current rates are good enough to carry her through retirement with very little risk.

Market Timing Doesn’t Mean Much

Because of the taboo we’ve placed on anything that could be described as market timing, investors are sometimes afraid to use all the available information when making their decisions. I do not think this is a good thing.

It’s OK to make investment decisions based on current interest rates or market values, so long as you remember that you can’t predict where they’re going next or how long it will take before “next” occurs.

January 5, 2011 3 comments

In the last two years, one assertion I’ve heard over and over is that the stock market a giant Ponzi scheme — it only works if everybody continues to feed it money, and it collapses when people take their money out.

A similar assertion is that the stock market is just a “greater fool game,” in which stocks’ only value lies in the hope that you can sell them at a higher price to a greater fool at some point in the future.

Both claims are nonsense.

Stocks Have Inherent Value

If the public at large decided that they wanted nothing to do with stocks, and they all pulled out (and this is, to a lesser extent, what goes on in severe bear markets), stocks wouldn’t become worthless. Yes, they’d be worth less, but not worthless.

For the value of a stock to go to zero, the company itself has to be worthless. As long as a company has intrinsic earning potential, a share of ownership in that company has value as well.

A Worthless, Profitable Company?

For example, imagine if the price of Verizon’s stock declined all the way to $0.01 and that this decline was caused purely by investor panic. That is, it had nothing to do with any fundamental change in the profitability of the company. With a share price of $0.01, the company’s dividend yield (based on its most recent dividend) would be 4750%! Even if the price never went back above $0.01, you could get an obscenely high return from buying at such a low price.

Of course, such a scenario would never occur. The price of a company doesn’t ever go that low unless there’s a fundamental decline in the company’s profitability. At some point, investors would step in to snatch up the high dividend yield, thereby keeping the price from falling further.

Owning, Not Just Selling

Yes, companies’ earning potential can decline, or even go to zero. But it’s not caused by people getting scared.

Unlike a Ponzi scheme or a “greater fool” game, stocks have an inherent value. And they have that value even if there’s no “greater fool” to sell to, and even without investors continually pumping  money into the system.

Now, to be fair, stocks do have a ponzi-ish aspect to them, in that their market value does go down when other people pull their money out. But to assert that stocks’ only value lies in their ability to be sold is simply not true. You can receive value by owning stocks, not just by selling them.

September 27, 2010 5 comments

Passive investors aren’t immune to the temptation to chase performance. We just do it by tinkering with our asset allocations rather than hopping between various actively managed funds.

For Example

Imagine two portfolios: Both have a 70/30 stock/bond split. Both have the same total costs. And both have identical holdings in the bond portion of the portfolio. The difference is that:

• Portfolio A is market-cap weighted, and
• Portfolio B overweights small-cap and value stocks.

Theoretically, Portfolio B should earn slightly higher long-term returns than Portfolio A because it carries slightly higher risk. Of course, there’s no guarantee those additional returns will materialize over any particular period.

All we know with certainty is that there will be some years in which Portfolio A does better and some years in which Portfolio B does better. And that can create a temptation to tinker: “Perhaps I should be overweighting small-cap and value stocks after all.” or “Perhaps I went a little overboard with the small-cap/value idea.”

However, picking either A or B and sticking with it is likely to beat the heck out of jumping back and forth between A and B, always moving to the one that’s done well over the last couple years.

Be Wary of Tinkering

The same thing happens with your allocation to REITs. Whether you allocate 5%, 10%, or 20% of your portfolio to REITs, there will always be years in which you wish your allocation was something different from what it is.

And with your U.S. vs. international allocation: Should 20% of your stock portfolio be invested internationally? 40%? Regardless of what you choose, there will always be some other allocation that’s done better.

Be wary of the temptation to tinker with your portfolio. It may be nothing other than chasing performance.

Or to put it differently: How we invest is at least as important as what we invest in.

December 28, 2009 7 comments

Possible Results

Keeping It Going

Other Considerations

August 3, 2009 5 comments