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Buy and Hold? Or Active Management?

Navigating your life savings through stormy markets

I would like to retire someday. Really retire, not the “break” I’m on now. I don’t need anything fancy, just a private retreat (with internet), my Zen garden, and feline companions. But what do I do about my long-term investments? How do I (slowly) grow my life savings so that I indeed have money to someday retire? There are two schools of thought on the issue. Rather, two religions. Buy and Hold vs Active Management.

Stay the course

One of the fathers of investing is Jack Bogle, the founder of Vanguard (full disclosure: I have an account there). Early on he noted that actively managed mutual funds, those funds where the manager picked what stocks to buy or sell, did not necessarily do as well as the comparison index. If the S&P 500 index or the Dow index (or any other index) does as well or better, why not simply create a mutual fund of the stocks of the index? As the manager no longer needs to do all that work — stock analysis, trading, etc. — management fees can be slashed. Hence the index fund was born, and the investment community has not looked back. To this day, most of the actively managed funds fail to beat the index (even the “closet indexers”) and even Hedge Funds have shown poor performance of late.

The mainstream advice is to invest in index funds and leave them alone: Buy and Hold. This is simple advice, and easy to implement for even the most novice investor. As all of us hope to one day retire, that makes all of us investors. Most of the time this strategy is easy to stick to, as the stock market grinds forward in a steadily upward direction. Until it doesn’t.

What happens when you wake up one morning to learn the market (and the value of your life savings) has dropped 10%, 30%, or even 50%? You still need to stay the course. . .

There are ways to mitigate this scenario. First, only invest money you need in the long-term, greater than 5–10 years from now. Then if you hit one of these Bear markets you have time to recover before you need the cash. Second, diversify into other investments such as bonds, which may also drop, but not as much. When deciding on an allocation, or ratio of stocks, bonds, and other things, your risk tolerance, and financial goals should be determined. In other words, what is the minimum amount of risk (stock) that you can carry in a portfolio and still meet your financial goal of retiring someday?

But what if you’ve run the numbers and the only way to meet your goals is to invest a significant portion in stocks? Perhaps not the usual, moderately risky, S&P500, but something more volatile like the Nasdaq. Stay the course?

Follow your rules

Look at the price chart of the S&P 500 (SPY) over the long term (“max” timeframe). Note that if you had money invested in the year 2000, after two Bear markets you didn’t get back to even until 2013! That’s well over a decade of lost growth potential. (But what about reinvested dividends, you ask? For that timeframe, the total annual return was around 2%. Treasury bonds can beat that with far less risk.)

The goal of active management is to get out before the big drops and get back in before the big upward moves. Simple in theory, but very difficult in practice. Not one, but two, correct decisions need to be made: when to get out and when to get back in. If you get one right, but the other wrong, you could find yourself selling low, then sitting on the sidelines as the market rallies all the way back up. . . Keep in mind that no one — and I mean no one — can accurately determine market tops and bottoms. You’ll need to be satisfied with close enough (within 10–20% approximately).

These decisions of when to exit and enter the market should not be arbitrary. They should be based on rules. For example, did the price of the S&P500 move below its 20-month moving average? Or, did the price drop below a specific percentage (that would cause you undue pain), like 20%? Some of the better strategies look at both market fundamentals (are stocks overvalued?) and technical indicators (like moving averages).

Regardless of which active strategy you choose, it will be emotionally tough to follow. Many times, you may see the market rally and want to buy back in, but your indicators are telling you to hold off. Your buy and hold friends are doing great! As your investment goals are decades away, weekly and even monthly moves should be ignored. But that’s difficult to remember when your life savings are on the line.

It’s during this vulnerable time that you’re more inclined to switch to a different strategy, one that is doing well. In other words, you are selling low out of one strategy and buying high into an alternative strategy. Do this a few more times over the years and you’ll really mess up your returns. Indeed, investors on average have returns that are far poorer than the index, despite all the encouragement to use index funds.

So even active management requires staying the course. Sigh.

We are human and we make emotional decisions, especially when it comes to our money. With Buy and Hold there is the risk that a market drop will be so painful that we’ll bail and sell low. Likewise, with active management, there is a risk that FOMO (“Fear of Missing Out”) will be so acute that we’ll bail on our strategy and sell low or buy high. Based on your own psychological makeup, which strategy are you more likely to stick with?

Image by pixel2013 from Pixabay.

Diving into the data

As a (former) scientist I love studying charts and graphs. Let’s run some numbers. (If you’re not a data nerd, that’s ok, simply skip to the next section.)

Portfolio Visualizer has an awesome (and free) set of tools to backtest any portfolio idea (nope, I’m not affiliated). Important reminder: past performance is no guarantee of future performance. Indeed, active strategies may be subject to “Backtest Selection Bias”. Those strategies you read about are the ones that did well based on market history. (How many potential strategies have been tossed aside because they didn’t work with the data from the last 20–30 years? Perhaps a few of those rejected strategies might be optimal for the next 20–30 years?)

These models can be run with 100% stock, but real portfolios are a mix of stock, bonds, and other assets. The advantage of this is rebalancing, which allows you to effectively sell assets when they are priced high and buy when they are priced low. This process of rebalancing can help alleviate the negative impact of bad markets in a Buy and Hold strategy.

To compare strategies, the Vanguard’s 500 Index Fund (VFINX) and Vanguard Total Bond Market Index Fund (VBMFX) will be used as a 50:50 portfolio (50% stock, 50% bonds). As some of the oldest index funds, both have decades of data available.

(Just to be clear, these exercises are not real strategies you should use, just simplified versions for demonstration purposes.)

Let’s start with Dual Momentum, a strategy originally developed by Gary Antonacci, where we’re either fully invested, or alternatively, assets are sold and held in cash (or rather, a money market fund). Every month the last several months of price action is compared to the risk-free rate (treasuries), and the two best-performing assets are kept. Some months it may be 50:50 stock and bonds, or 50:50 stock and cash, or 50:50 bonds and cash, or 100% cash (money market fund). As we don’t know which performance look-back period works best, we’ll evaluate several: 6-, 12-, 18-, and 24-months.

Another strategy is the Moving Average model. Based on a monthly evaluation, stay in VFINX and/or VBMFX if the price of each is above their respective 3-, 6-, 12-, or 24-month moving average; if not move to cash.

As this second tool provides additional flexibility on asset allocation, we’ll also evaluate an 80:20 portfolio (80% stock, 20% bond). A portfolio with a high percentage of stock will be more sensitive to drawdowns.

In the tool, all buy and hold portfolios are balanced monthly, to correspond with the monthly evaluations in the active strategies, which effectively become rebalanced every time assets are switched. Note that in the real world, balancing does not need to occur quite so often.

We may follow the growth of a single initial investment ($10,000) with no additional savings along the way. However, we all should be contributing to our savings every year, for example, $6000, the current IRA contribution amount. Adding to our savings on a regular basis also introduces Dollar Cost Averaging, where we buy more shares when prices are low and fewer shares when prices are high, effectively buying low. Like rebalancing, this technique helps lessen the negative effect of bad markets in a buy and hold strategy.

30 years (1989–2019)

$10,000 initial investment followed from Jan 1989 to April 2019. The annual contribution was adjusted for inflation (increased over time). All values rounded. MA=Moving Average. Winners highlighted.

And the winner is. . .

When I first started playing with these tools, I chose a 100% stock portfolio and found the results inconclusive. But once I split the portfolio into stocks and bonds and rebalanced, the results became very clear. (Compare column five to column seven.) In almost all scenarios Buy and Hold won out (see highlighting). However, there is very little difference between the two, and much of the variation is most likely not significant. (Disclaimer: I’m not a statistician.)

Put another way, there is no advantage to the Active Strategy over the Buy and Hold Strategy. As Buy, Hold (and rebalance) is a much easier strategy to implement, both logistically and psychologically, it’s the one most of us should use.

But Not So Fast. . .

The maximum drawdown for the S&P500 during these 30 years was over 40% in the 80:20 portfolio (or >50% for the stock portion), but less than a third of that for the active strategies. This is a significant difference in your pain threshold. As such, you may be able to invest more aggressively (a higher percentage of stock) with an active strategy, with the potential to make more in the long run. (Or not.)

The results above assume the next 30 years will behave like the last 30 years. Markets are cyclical so we should expect another one or two bear markets. But they won’t be like the ones we’ve already experienced.

Indeed, what if you started saving late and only had 15, not 30, years of growth? And perhaps you saved during the wrong time when markets were performing at their worst. Let’s rerun the scenarios, but during the “lost decade” including two significant bear markets: in 2002 and again in 2009, the S&P500 bottomed with a maximum drawdown (drop) from the recent high of over 50% each time.

15 Years, including the “Lost Decade” (1999–2014)

$10,000 initial investment followed from Jan 1999 to Dec 2013. The annual contribution was adjusted for inflation (increased over time). All values rounded. MA=Moving Average. Winners highlighted

Not surprisingly, this situation favors the Active Management strategy, as we would expect bear markets to favor an active strategy and bull markets to favor buy and hold. However, like the 30-year exercise, in most cases the differences are small.

Yes, there are a few scenarios that stand out, including one with over a 40% gain relative to the buy and hold choice (line 10, above). But given all the unknowns about the market in the future, can those results be replicated in real life? It’s highly unlikely.

As a scientist, I’m not supposed to “cherry pick” data, or in this case, timeframes. However, the point of this is that we don’t know what the market will bring in the next decade, or several decades. Most of the time buy and hold will be the better strategy, but on occasion, an active strategy may prevail, especially during a “worst case” scenario.

Do you take on the added risk of an active strategy on the off chance you hit a bad decade? In addition to slightly poorer performance overall, active strategies have an extra risk in that they were optimized for the markets of the past which may or may not correspond to the future.

It should be noted that even the staunchest advocates of the active management approach do not recommend applying it to all your savings. When the rules trigger, only sell, 25% or 50%, and leave the rest alone. In other words, always keep a portion of the portfolio buy and hold. So along with a portfolio diversified in different investments, the strategy itself is diversified. On both counts, diversification reduces risk.

Even if you do follow a passive buy and hold strategy, that doesn’t preclude you from applying other “active” measures, such as option hedges. Likewise, there are other strategies for managing “sequence risk”, or the risk you’ll hit a bad decade at the worst possible time, such as early in retirement. (More on that in future posts.)

If your timeframe is 30-plus years, then buy, hold (and rebalance) is the obvious choice. Remember, even if you’re retired, your savings will continue to grow — hopefully for several more decades — so those years should be considered as well. Just make sure that when you do retire, you have enough allocated to low-risk assets such as bonds and cash equivalents, to live off while weathering a stormy market.

Disclaimer: This information has been provided for educational purposes only and should not be considered financial advice. Any opinions expressed are my own and may not be appropriate in all cases. Please seek out a licensed professional for advice specific to your situation.