I recently came across this clip of Suze Orman discussing passive, index investing. In it, she provides us with the following insight:
“I’m not sure you can buy and hold that way and just forget about everything as if everything will be OK.”
If you look around the realm of personal finance (online or offline), you’ll be inundated with similar messages. Two quotes from recent emails I’ve received appear to be perfect examples:
“Over the last decade, we’ve learned that passive investing doesn’t always work.”
“Passive investing only works during bull markets.”
In other words, as Jason Zweig recently stated, “today, it has become trendy to declare that ‘buy and hold is dead.’”
Got a better idea?
Will buy & hold index investing ensure that you reach your goals? That depends to some extent on what your goals are, but the honest truth is that no, it probably can’t guarantee that you’ll reach them.
A more meaningful question, though, is whether there is a better alternative. Can we hope to do better by using some other strategy?
To be able to earn a return better than that provided by a long-term, buy & hold indexing strategy, we have to either:
- get lucky, or
- outsmart the market in some way
Outsmarting the market
All the various methods for attempting to outsmart the market can be broken down into two broad categories:
- picking stocks (or other individual securities), or
- timing the market
Picking Stocks
My rule of thumb before investing in an individual stock is to ask myself whether I have any information about the company that would not already be known to somebody whose full time job it is to stay informed about the industry the company is in. If I can’t answer in the affirmative, I don’t buy the stock.
(To date, I’ve never answered in the affirmative, though I don’t entirely rule out the possibility of it happening someday. 
)
Timing the Market
The difficulty of predicting short-term market movements is analogous to that of picking individual securities: Short-term market movements are the result of new information being released. To be able to predict the market’s movements, you need to know something that the rest of the market doesn’t yet know.
It’s not perfect…
Long-term, buy & hold, index investing is far from a perfect strategy. But a declaration that “buy & hold is dead” is worthless unless coupled with a strategy for doing better.
And let’s not forget that every effort we make to “do better” puts us further behind as a group.
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Financial experts are quick to say what doesn’t work after it hasn’t worked. Buy and hold was always the sacred cow when in a bull market.
I agree with you that buy and hold is only useless compared to something better.
Mike:
You are right on to say that the claim that “buy-and-hold is dead” is pointless unless something better is put forward to replace it. And your arguments for why many of the possible something betters are not going to work out are strong, in my assessment. But I noticed that, when you pointed out the problems with timing the market, you limited your criticism to short-term timing. I cannot help but wonder if my message that long-term timing is The New Buy-and-Hold has influenced you a bit.
I have had a lot of people hit me with bricks because of my advocacy of Valuation-Informed Indexing (long-term market timing). This has made me sad because many of the people throwing the bricks are people I respect (people who advocate Passive Investing). It’s not my intent to force anything on you. But I want you to know that I am always open to doing anything that can be done to help you or any of your readers come to a better understanding of why Valuation-Informed Indexing really is the indexing strategy of the future.
Many of the Passive Investing concepts are pure gold. The problem is that humans make mistakes and the people who came up with the Passive concept are humans. If we could get past the friction and work together (I don’t mean you and me, I mean the broader community of people interested in buy-and-hold strategies), we could put to rest these criticisms of buy-and-hold and promote a model of far more long-lasting power that has much in common with the conventional buy-and-hold but avoids its weaknesses.
I believe that both sides are right re this one. The Old Buy-and-Hold really cannot ever work. But there is a new approach to Buy-and-Hold open to us that offers great potential. It is not the idea of sticking with a strategy for the long term that is flawed. That is pure gold. The mistake was the thought that there is no need to make adjustments in one’s stock allocation in response to big price swings. When we fix that one, we are off to the races with something better than what we have ever had before.
Passives are right about so much. But they need to develop the grace to acknowledge the things that they got wrong if we are to move the Indexing Revolution to the next natural stage in its development. If we develop the courage to take that step, we could change the history of investing in a very, very positive way.
Rob
I know my comment is sort of the anti-message of this site, but isn’t a reasonable (VERY reasonable in my opinion) third option – hire a professional?
I know there are some fees, there may be questions of motive, etc. I have heard all the arguments against it. But can’t we hire an “Uncle Toby” (like the reference?) or even a couple Uncle Tobys that have THEIR style?
I think one of the troubles we run into is the caricature of Buy and Hold and Passive Investing as something that you “set and forget” and blindly adhere to. Even with such investment strategies, it is important to re-evaluate your portfolio every so often (I do it one a year) to see whether it is still what you want it to be, and whether it is going to continue to help you reach your goals.
Rob: Yes, I do see (at least a potential) value in adjusting asset allocations as a function of current price levels. But to be honest, I see the misinformation spread by the financial services industry (about active management, picking stocks, etc) as a far larger issue. And until that battle is won–which I doubt will ever completely happen–I don’t foresee myself taking on any other issues with my writings.
MyJourney: Yes, in theory, we could hire somebody to outperform the market. The problem, however, is twofold:
1) Any attempts to outperform will, by definition, decrease the total return earned by investors as a group, and
2) Picking outperforming funds ahead of time is nearly impossible. Multiple studies have shown that–within an asset class–expenses are the best (and perhaps the only) predictor of future performance. That leads unquestionably to the conclusion that index funds are the way to go.
Miranda: Agreed. Regular checkups are essential. Admittedly, the brand/logo of this blog probably doesn’t help to combat the caricature you mentioned, hehe.
What upsets me is the “experts” often act like babies.
Any approach to investing will involved periods of poor performance. I am not a market timer but I’m not a buy and hold either.
My strategy has its pros and cons – like anything else in life. The issue is that folks hop around looking for the “perfect” approach…and end up in Bernie Madoff’s office.
Regarding professionals with all the info-
This assumes the conclusion that having more info is an advantage. Psychological studies have shown that test subjects perform more poorly in analytical tasks when they are exposed to increasing levels of and varieties of information about a query.
Based on what I’ve read from Graham and Zweig, “buy and hold” seems to work when you buy the security at a greatly undervalued price and when the company provides consistent dividends.
To assume that securities can never be undervalued (EMH) is to say that investors are never irrational or acting on fear or herd mentality.
Mike, your argument seems to be similar to what Winston Churchill once said about democracy: “Many forms of Government have been tried and will be tried in this world of sin and woe. No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of government except all those other forms that have been tried from time to time.”
Perhaps passive index investing is the worst form of investing apart from all those other forms that have been tried from time to time? (Which actually makes it rather good, like democracy!)
Rob: Yes, I do see (at least a potential) value in adjusting asset allocations as a function of current price levels.
Thanks for saying that much, Mike. I am grateful.
But to be honest, I see the misinformation spread by the financial services industry (about active management, picking stocks, etc) as a far larger issue. And until that battle is won–which I doubt will ever completely happen–I don’t foresee myself taking on any other issues with my writings.
I am of course disappointed to hear this. But that’s of course your call.
My take is that it is this way of thinking that puts the good stuff in the Passive model in jeopardy. Ultimately, people are going to go with what they think works. During a wild bull, it was possible to make it look like Passive could work. Now that that’s no longer the case, we’re going to see more and more people coming out and saying the sorts of things that you are noting in this blog entry. My thought is that we have no choice but to fix what is wrong in the Passive model if we hope for the model to survive to help investors of future days.
It’s not by attacking the attackers that we prevail. It’s be taking a good look at the man in the mirror and fixing the things that we really are able to fix. It’s harder work from one way of looking at it. But it’s work that pays big dividends (in my view). My view is that it is those of us who are seeking to fix the Passive model who are the true Bogleheads.
Rob
You have nice arguments aginsts the assumed premises. But your premises are wrong.
“To be able to earn a return better than that provided by a long-term, buy & hold indexing strategy, we have to either: get lucky, or outsmart the market in some way:
1. picking stocks (or other individual securities), or
2. timing the market”
First you do not have to get lucky or outsmart the market. All you have to do is avoid debacles. Profits are good. Small losses are acceptable. Killer losses destroy the best laid plans.
Second, there is no need to pick stocks or time the market. If you want passive investments, go for it. No need to do anything different when choosing investments.
By adopting conservative option strategies (specifically the collar), an investor can earn good, but limited, profits when the markets rise; earn a small profit when the markets are stagnant; lose a small amount when the markets fall; and still have small losses when the markets tumble. Those tumbles don’t occur that frequently, but are devastating when they do. It’s easy to get complacent (technology bubble) when markets are rising.
Owning portfolio insurance is a smart idea. It means the investor is prepared, not hoping to get lucky.
There is no reason not to learn how options work. Then – and only then – can an investor make the decision that ‘using options is not for me.’
I appreciate the opportunity to present my thoughts here. Thank you.
http://blog.mdwoptions.com/options_for_rookies/2008/07/example-of-a-co.html
@MyJourney
The data is irrefutable: professional money managers cannot outperform the markets on a consistent basis. All they do is tack fees onto that below average performance.
One of the sad truths on Wall Street is that the salespeople are out for themselves. Sure there the honest minority, who understand and respect the meaning of a fiduciary responsibility, but those are difficult to find.
As long as there is a conflict of interest – and charging fees is that conflict – the customer is not going to be well served by professionals.
Mark: I’d still lump that idea in with “outsmarting the market.”
In order for an options strategy (collars included) to earn a greater return at a given level of risk than, say, a simple stock/bond allocation, the options you’re buying must be underpriced and/or the options you’re selling must be overpriced.
For reference, I’m not saying that options strategies are a bad idea, per se. I’ve just never seen anyone make a compelling case that they reduce risk at smaller cost to expected return than simply increasing the fixed income or cash allocations in a portfolio. Meanwhile, getting involved in options certainly increases the complexity level over simply controlling risk via asset allocation, and, all else being equal, increased complexity is obviously not a good thing.
“increased complexity is obviously not a good thing.”
I can agree with that. But what if increased complexity made a significant increase in annualized returns?
I believe that preventing disasters is all that’s necessary for long-term wealth. But that’s okay – we don’t have to agree. There is no single best way to handle one’s money.
I’ve been hearing/reading a lot about the death of “buy and hold”. But it was my understanding that if you are 100% in stocks there is a great likelihood that at some point over a thirty year period where you will lose 50% of your portfolio’s value. I learned that “rule” years ago, and lo and behold 2008 comes along and that is exactly what happened. To me that was not proof that it didn’t work, it was vindication that its advocates knew what they were talking about.
If I had been close to retirement, I wouldn’t have been so heavily allocated in equities, that’s another thing the B&H advocates say. While I was disgusted that the money I put in my IRA seemed to disappear almost as soon as I put it in, I kept at it, and my biggest losers were averaged enough by new contributions that they are now my biggest gainers.
I believe a B&H strategy will work in the long run. But I will say that in my taxable account, which I beefed up tremendously in the downturn, I only do ETFs so I can have stop loss orders on them, and I am not scared to take a profit, pay The Man his cut, and run.
Buy and holding stocks in an economy that is not likely to grow for years mean your stock portfolio will give you the same thing, punitive returns. Good quality stocks paying you a dividend with no potential of growth, holding an index fund that will mirror poor economic growth for years does not seem the way to go in this new arena of investing. Passive investing and buying and holding just mean that you are going to get another zero on your investments in 10 years.
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