Buy and Hold Investing Redux

Thou speakest wiser than thou art ware of.

Shakespeare, As You Like It


As regular followers know, I have been posting a series of blogs that will eventually amount to seven tips for investing based upon my foray into this world over the last decade or so. The last post was one which I knew would leave me frustrated and dissatisfied. The topic (Exploding the Myth of Buy and Hold Investing) is so vast so as to justifiably warrant treatment as a book. No blog entry (no matter how grandiloquent) could possibly suffice in adequately covering the subject. I found myself omitting point after point, for fear that each new issue would spawn several others which should logically be examined.

Reader Ruminations

I was already considering a follow-up blog attempting to fill in some of the larger gaps in my analysis, while clarifying and qualifying other points, when one of my more intellectually gifted friends posted the following comment:

Hi Mark,
Thanks to your posting, I have learned that I am a proud member of the Boglehead tribe. However, it is not because I believe the market is efficient and rational, as you suggest. In fact, I love reading the clever books by behavioral economists who demonstrate how irrational we all are. The problem is that I think it is just as hard to predict a crash as it is to predict a winning asset class (maybe harder). Thus for me, targeted short selling would likely be disastrous, especially given my lack of willingness to spend a lot of time researching. So, buying and holding low cost, diversified investments still seems like the least bad strategy (unless you have some great inside information you are willing to share!). As a way of illustrating my position, the last time I noticed your posting, it was in March, 2009 and you were giving the general advice to stay out of the market due to the pervasive financial uncertainty. Being a Boglehead who blindly feeds my 401K in all markets, I didn't listen to your advice and I now am a lot richer as a result. I am sure another crash is coming sometime and somewhere, but at this point, I am planning to continue to keep on Bogling. As a fall back, I plan to never retire.
I really enjoy your blog!
Happy Holidays! Joel Schmidt

A very thoughtful and articulate comment, thanks for the feedback, and Happy Holidays as well, Joel. Indeed, I believe there is no shame in being a proud Boglehead. He is not only one of the sharpest minds to have gained prominence on Wall Street, but he also has perhaps the purest heart (a far rarer trait in the world of finance). I have in the past referred to him as the (Living) Patron Saint of Investors. I highly recommend his books, most notably Common Sense on Mutual Funds.

Joel does bring up the most difficult element associated with NOT being a buy-and-hold-forever investor -- timing. Bogleheads correctly point out one actually has to be right about timing not just once, but twice: when to initially get in (out) of the market, and then when to get out (back in).

Let me be VERY clear about something. I do not (at least conventionally) in any way advocate market timing. Quite the contrary, I make virtually all of my investment decisions with a window of at least five, and usually closer to ten or fifteen, years. Despite making my living as an investor, I have gone almost six months at a time without executing a single transaction.

I depart from the Bogleheads in that I believe at the extremes (in terms of time, market sentiment and valuation), it behooves an investor to make discretionary buy and sell decisions. I would characterize my investing philosophy as buy-and-hold-until-the-asset-becomes-overvalued. Or maybe buy-and-hold-until-an-even-more-undervalued-asset-presents-itself. Given the unwieldy nature of either moniker, an imminent how-to book by yours truly is not in the cards.

Mania Mentality + Paltry Dividends = Market Avoidance Therapy

To specifically address Joel's comment, and while possessing no insider information whatsoever (actually resolutely classifying myself as an outsider), I think there are at least two ways in which to identify a coming market crash. The first is very unscientific, and which I have mentioned in the past - mania mentality. Investing should be about as much fun as watching paint dry. Slow, steady and relatively modest returns should be the norm. Similarly, investing in almost every normal era in American economic history is something off the radar screen of most individuals.

Conversely, when people experience stratospheric returns far in excess of long-term norms for a particular asset class, and/or when millions check the balance of their 401(k) account to gleefully take note of their capital gains more often than they check the weather forecast, these are signs that bubble mania is rampant. In times like those (say 2000 for stocks, and again with the housing market in the years thereafter), history shows us that even over the medium-term (say 5-15 years), one is better off avoiding the asset class in question.

The second, more scientific, method for identifying overvalued assets is to look at relevant quantitative data. I will admit that for the lay investor who does not want to devote much time managing her portfolio, most of these numbers will be too arcane. Specifically, as a deep value investor, I look to such metrics as price-to-book, price-to-cash flow, price-to-earnings growth, and the like. But let me give you one quantitative measure that is accessible and (hopefully) understandable to the lay investor: dividend yield.

For many decades, dividends made up half, and oftentimes more, of the total returns that investors received (capital appreciation being the other component). Between 1945 and 2001 the dividend yield for the overall US stock market averaged 4.1%. When dividend yields come down dramatically, this is almost invariably the hallmark of an overvalued market that is destined to fall.

An Illuminating Illustration

Let me use an example to help demonstrate why this is the case. Let us assume that ACME Inc. is a hypothetical company which is huge and diversified. As such, its stock price is representative of the market as a whole. At the beginning of Year 1, it is selling for $25/share and pays a dividend of $1 (hence a 4% dividend). That same year, investment fever begins to spread throughout the country (since this is a hypothetical, pretend the last 10 years never happened and that investors are not so shell-shocked) and the economy is deemed quite healthy. ACME's stock price jumps, closing out the year at $40.

Now this is an important point, and one of the reasons why dividend yield can be a helpful valuation tool for assessing stock markets -- companies do not tend to increase or decrease their dividends significantly from year to year. This is unlike almost every other investment metric that can vary wildly (stock price, PE ratios and earnings being the most notable). Even after a blockbuster year, companies are loath to significantly boost dividends. This is because dividends are generally paid from the free cash flow, and companies do not want to overextend should their fortunes quickly reverse. When a company announces a dividend cut, this is seen by the market as a sign that it must be in dire straights. The market usually punishes such an announcement with a marked drop in its stock price. Therefore, in a great year, a company like ACME might increase its dividend a fairly modest 5%, to $1.05. This leaves the dividend yield at the end of Year 1 at 2.6% (dividend of $1.05 divided by its stock price of $40).

In Year 2, market madness continues. ACME's stock ends the year at $65, and the rest of the market moves up at a similar pace. After another great year, ACME boosts its dividend to $1.10, driving its yield down to 1.7%.

Finally, in Year 3, as investors everywhere are building castles in the air, ACME's stock soars to $105. After another solid year of earnings, the company boosts its dividend to $1.16/share. But now the yield has plunged to a scant 1.1%.

So, what is an investor to do? A typical lemming would, after all the amazing returns had been already achieved, plunge as much money into stocks like ACME as possible.

The buy-and-hold-forever investor would have already achieved great returns owning ACME and other stocks like it in broad-based index funds throughout it stock price ascendancy. However, this same investor would continue accumulating the ACME's of the market (even after a 300% price appreciation) every payday in her 401(k)/IRAs/brokerage accounts.

The contrarian/buy-and-hold-until-the-asset-becomes-overvalued investor would bail, concluding that the combination of bubble mania, as evidenced by market psychology, and terrible valuations, as measured by dividend yields and other metrics, create an awful prognosis for ACME and comparable companies going forward.

Back to (Harsh) Reality

Now the dividend and price appreciation numbers used in the aforementioned example were not selected haphazardly. For simplicity purposes I condensed the time frame, but between 1990 and 2000, the S&P 500 also increased more than fourfold in price, while its dividend yield plunged from 4% to a paltry 1.1% (an all-time low). This was about as close to a clarion call for an asset bubble as one could ever expect to see.

Please note that the superiority of contrarian investing over the buy-and-hold-forever approach is not remotely based on precise market timing. I stopped buying US equities at the end of 1998, more than a year before the S&P peaked. As such, I missed out on one of the S&P 500's best years, watching from the sidelines as it gained more than 20% in 1999. But when the market tanked (which it always does after an asset bubble emerges), I and my contrarian ilk were quite happy to have forgone the final ephemeral burst of gains as the market sine curve reached its apex.

The lack of importance of market timing (at least as measured by reasonably short durations of time) for contrarians such as myself is further highlighted by the fact that even after the S&P temporarily bottomed in October 2002, I did not purchase any US equities (other than select energy and mining stocks whose performance was largely unrelated to the overall US market). Why? Even at much lower price levels, US stocks did not represent a good value proposition. The dividend yield for the market did not even rise to 2%. Moreover, as detailed in other posts below, another asset bubble was fomenting in the residential real estate market. This was artificially propping up the US economy (which from a fundamental perspective looked disastrous). Accordingly, it appeared obvious that lower lows were coming for US stocks. So long term, patient contrarians such as myself watched as the market went up more than 70% in the next five years, convinced this was the mother of all headfakes in the market.

Essentially this "ought" decade was a lost one for equity investors in all three of the major markets (US, Europe and Japan). Actually, any investor who avoided investing the the US stock market after August 1996 would have been rewarded by having a lower entry point on her investment. This again highlights how unimportant market timing is. Well, let me qualify that. A colleague of mine once coined the term "meta-market timer" to describe me after hearing my approach. I think that is fair. With a decade-long time horizon, I think a diligent and enlightened investor is able to identify both attractive and unattractive assets from a valuation perspective and act accordingly.

I should note that while I have personally engaged in the short-selling of assets I deemed to be overvalued, particularly in 2000 and 2007/2008, that it would, as Joel correctly mentions, be a disastrous approach for 99%+ of investors. Rather, the strategy I advocate for almost everyone is simply to avoid these overpriced assets if you do not have them, and sell them if you do. One only has a limited supply of money to invest, so why tolerate exorbitantly priced assets in one's portfolio? Or, looked at slightly differently, why would one not want to sell and reap the profits when asset prices are dear?

Of Automaton Investing and Lost Opportunity

This segues into my last criticism of the buy-and-hold-forever approach. It treats broad-based (generally US) stock and bond indices as the only asset classes investors should consider. Even before I disavowed my membership as a Boglehead, I recall reading in his book on mutual funds that an investor should not look any further than within our borders for investment opportunities. This is sort of like a prospective auto buyer arbitrarily limiting herself to only purchasing Jeep brand vehicles (apologies to any Jeep owners out there).

There is a huge opportunity cost associated with restricting one's investments to total market stock and bond index funds, particularly when one further limits their holdings to US based assets. For instance, while investing in broad-based equity indexes was dead money (or worse) in the last decade, it was a spectacular time to be invested in precious metals (gold in particular was up 300%+), energy, agricultural commodities, industrial metals, and companies producing all of these assets. Emerging markets also performed very well vis-a-vis more developed markets. Some of the best opportunities in currency markets also presented themselves (shorting the dollar and pound, going long the Canadian dollar and yen).

When an investor limits oneself to a narrow spectrum of investments, buying those assets every payday no matter what the cost, and then does not sell even when prices obtain dizzying heights, she will inevitably achieve suboptimal returns. These returns will almost invariably best those of the lemmings, as well as those achieved by investors relying upon expensive, fatuous financial services professionals. Hence, as mentioned in my last post, buy-and-hold-forever investing is the "least bad" approach to managing one's finances that does not depend upon some level of valuation analysis.

Now What Did I Say Again?

One problem with writing a blog with the limited intellectual resources yours truly possesses is remembering what I penned. Joel correctly noted that Bogleheads have been rewarded since the market lows in March by having money in stocks. His recollection was that at that time I was encouraging people to stay out of the market.

I looked back upon my posts during that time. I was certainly blustering invectives against the moronic policies of both the federal government and the Federal Reserve, arguing that these actions would be counterproductive to the long term health of our economy. I also contended that these policies would be largely futile in terms of affecting the real economy even in the short-term, and with unemployment at 10% and underemployment at 17%, I stand by that assessment. I also mercilessly took Wall Street to task for its rank hypocrisy in advocating government bailouts of the financial services industry, while for decades arguing that the government should refrain from intervening in the free markets when it better suited their interests.

But I could not find anything imploring investors to stay out of the stock market. Indeed, the most recent post relating to specific investment advice I could come across was from February 4, entitled Portfolio Reclamation Project. In that blog entry, I first commented upon the nature of the 45% market crash from its October 2007 peak. I then made three specific buy recommendations: TIPS (up more than 8 1/2% while comparable long-term treasuries are down almost 20%), gold (up about 23%) and (for the first time since 1998!) high quality stocks. I was specifically bullish on Microsoft (up 64% compared to a 30% increase in the S&P 500 index).

Why the change from my bearishness expressed as recently as July 2008? Attractive valuations!!! For instance, the market crash drove dividend yields for the S&P 500 up to 3%+ for the first time since 1991! To add icing to the cake, rock bottom stock prices were coupled with a contrarian's dream - horribly negative sentiment. Virtually nobody wanted to own stocks. Baron Rothschild back in the 18th century is reputed to have said, "Buy when there is blood in the streets." This investment advice has withstood the test of time, and is just an extension of my first tip -- do not run with the crowd/lemmings. It is almost without exception in your financial self-interest to zig when others zag and vice-versa (at least when sentiment extremes of despair and euphoria manifest themselves). So I was backing up the dump truck and loading my portfolio with plenty of stocks that were selling for bargain basement prices (most of them were not US stocks, but many were).

The Best of Both Worlds

So I certainly do not fault Joel's analysis that by staying in the market and adding to his positions no matter what market conditions present themselves, he is richer for it since March. But so are those of us who are contrarians and saw the market crash as a tremendous buying opportunity. An important difference is that those of us who were out of the stock market when prices were exorbitant did not see a 50% haircut in our stock portfolios between late 2007 and March of this year. Investing really is as easy as "buy low, sell high."

I do not expect to post another entry until after Christmas, so let me wish everyone a very blessed and joyous holiday season!!