The Death of Buy-and-Hold? 

Don’t Read This at the Funeral

May 6, 2010

One topic of conversation at our last Monarch lunch, on April 14, was about buy-and-hold.  We unveiled some rather eye-popping statistics, so for those of you who couldn’t join us, we’ll recap the discussion here.

For those who spend too much time watching the talking heads on CNBC, or reading newsletters from investment advisers (except for ours, of course), you might have noted that the “buy and hold” strategy is dead.  How can a strategy be dead?  Because it failed to work! 

After a decade during which stocks generated a total return (price appreciation plus dividends) of +433% in the 1990s, the 2000s generated a total return of -9%.  Note that these are figures for the S&P 500, not your account.  Nonetheless, for those who felt they were not being sufficiently rewarded by the market for putting their investment dollars at risk, the superior idea (to some) has been a strategy with a simple name, but a much more complicated implementation process:  “trading.”  If you’re invested in something that “isn’t working” (yes, that’s a long-established buzzword in our industry), you need to get out if it and into something that is working.  If you’re in something that is working, ride it until it stops working.

Unfortunately for most investors, this is much easier to say than do.  If you’re right 50% of the time with your trades, and wrong 50% of the time, Math 101 would indicate that your expected return for investing in stocks in the 2000s would be….still –9%.  And if you’re confident about outsmarting the market and getting more than half your trades right, you would be wise to remember that emotion dictates most peoples’ trades.  And the results of trading emotionally….

We have long known the results of the famous “Dalbar studies,” which show the average returns from stock mutual funds, compared to the average returns that investors in those funds got.  While that might sound like the same thing, let us explain the difference.  Money flows into and out of mutual funds every day.  A hot fund attracts more money into the fund, called “inflows,” than money which leaves the fund—“outflows.”  Cold funds are on the outflow program.

The timing of all these inflows and outflows are not random.  They coincide with the backward-looking performance of the funds.  So, after a fund has just had its best days is when it attracts a ton of new inflows.  After the fund does terribly, then the outflows happen.  So, a fund’s size typically peaks just before its lousy streak begins. 

Dalbar updates its studies every year, and the results have been consistent since their first major study, covering the 1984-2002 period.  This study showed the average annual return from stock mutual funds to be +9.3% (which was well under the S&P 500’s return of 12.2%), but the average fundholder’s return was only +2.7% annually.  That’s a 6.6% gap!  The cumulative (not annual) return was +442% for the funds, but only +66% for fundholders.  Gaps of other time periods have ranged from 6.5% to 8.0%.  Stocks aren’t unique either:  a study of bond funds from 1986-2005 showed bond fund returns of +7.4% annually, but only +0.8% annually for fundholders.

These are shocking numbers, not to be taken lightly.  They can be explained by two different phenomena, both driven by the same root cause.  First, investors move between hot funds and cold funds at the wrong time, on average.  Second, investors move between asset classes (like, from stocks to bonds) at the wrong time.  Someone in our business once said:  “the investor who buys into the hottest performing segments of the market is similar to planting corn in October since it had grown so well since April.”

So why are we bringing up the subject now?  Because we have data on a single mutual fund from the decade of the 2000s.  This is no ordinary fund; it was the best performing mutual fund in the decade.  It is CGM Focus Fund, managed by Ken Heebner.  The fund started off the decade strong by loading up on homebuilders and mortgage banks, and managed to get out of them just as they were peaking, and moved into commodities in the middle of the decade.  Unfortunately, it held onto commodities too long, and rode them down in 2008 and 2009.  The fund’s returns are notoriously volatile, given that it invests in only a small number of holdings and is usually highly concentrated in one industry.

The fund returned +18% annually for the decade.  However, investors in this fund, the best performing fund of the 2000s, lost 11% annually for the decade.  For the math-challenged, that’s a 29% gap!!!  We’ll assume this is highly unique, and perhaps the biggest performance discrepancy of any fund.  But at least it confirms the Dalbar data, and it likely demonstrates that the more volatile the investment, the more bad decisions investors are prone to make.  Trading J&J’s stock probably won’t get a trader into too much trouble.

While we do believe we can add value by moving money between stocks, and into new stocks, we also recognize that it won’t work every time.  We also understand the value of patience, which is probably the closest antonym that exists to the term “trading.”