Is “Buy and Hold” Dead?

Is “Buy and Hold” Dead?

In short, the answer is “no”.  Can an investor be successful employing traditional “buy and hold” strategies?  Probably.  But “success” in this context is a relative term.  What an investor should be asking is “are there superior alternatives to ‘buy and hold’”?

Several years ago, we developed what we call “The Determinants of Success” for money and investing.  There are three:

1. Have a plan

2. Maintain Proper Asset Allocation

3. Behavior Management

We talk a lot about these three determinants of success and base everything that we do on them.  The reason is simple: the “determinants” serve as a guide-or even a foundation-to and for all planning, investing and behavioral decisions regarding the two.  Yes, plans need a tweak from time to time and with this tweak may come a change in asset allocation.  A change in behavior should never cause a change in the other 2, but a change in one or both of the other two may cause, or require, a change in our behavior.

It is hard to quantify which is the most important of the three.  To do this would be like trying to determine which leg of a three-legged stool is most important.  It is impossible; they are all equally important.

Rebalancing Act

We have spoken and written countless times about the importance of diversification.  Global diversification gives investors a valuable tool for managing risk and volatility in a portfolio.  But smart diversification has an important side effect.  It requires maintenance.

In a given period, asset classes experience divergent performance.  These dissimilar price movements are not only inevitable, they are, in fact desirable.  A portfolio that holds investments in asset classes that do not perform similarly (i.e., as one asset class zigs, another may zag) will experience less overall volatility.  This results in a smoother ride over time.  However, dissimilar performance also changes the integrity of your asset mix, or allocation-a condition known as “asset drift.”  As some assets appreciate in value and others lose value, your portfolio’s allocation changes, which affects its risk and return qualities.  If you let the allocation drift far enough away from your original target, you end up with an entirely different portfolio.

This is where traditional “buy and hold” strategies lose out.  In the “buy and hold” approach, an investor does exactly what the name refers to: they investor buys an investment and holds it for an indefinite amount of time (whether that is “forever” or until the individual is convinced to buy-and hold-a different fund).

Once an investor has formed a portfolio to match current investment goals and risk tolerance, the structural integrity should be preserved since asset allocation accounts for most of a portfolios return (Gilbert L. Beebower , Gary P. Brinson, and L. Randolph Hood, “Determinants of Portfolio Performance ,” Financial Analysts Journal 42, no. 4 (July/August 1986): 15-29. Gilbert L. Beebower, Gary P. Brinson, and Brian D. Singer, “Determinants of Portfolio Performance II: An Update,” Financial Analysts Journal 47, no. 3 (May/June 1991): 40.)

In order to efficiently pursue investment goals, we must manage asset drift.  Rebalancing is the remedy.

To rebalance, assets that have risen in value must be sold, just as we buy more of assets that have decreased in value.  As we have always been told about investing, proper asset allocation requires that we buy low and sell high - every quarter.  The purpose of rebalancing is to move the portfolio back to its original target allocation.  This restores strategic structure in the portfolio and puts your portfolio back on track to pursue your long-term goals.

Counter-Productive?

At first glance, rebalancing seems counter-productive. Why sell a portion of outperforming asset groups and acquire a larger share of underperforming ones? Intuition might suggest that selling previous winners may hinder returns in the future. This logic is flawed, however, since past performance may not continue in the future-and there’s no reliable way to predict future returns.

Equally important, remember that your original asset allocation was established relative to your risk and return preferences. Rebalancing realigns your portfolio to these priorities by using structure, not recent performance, to drive investment decisions. Periodic rebalancing also encourages dispassionate decision making-an essential quality during times of market volatility and this includes periods of seemingly inescapable fear and irrational exuberance. Moreover, if and when your overall financial goals or risk tolerance change, you have a foundation for making adjustments. In the absence of a plan, adjustments are a matter of guesswork.

No one knows where the capital markets will go-and that’s the point. In an uncertain world, investors should have a well-defined, globally diversified strategy and manage their portfolio to implement it over time. Rebalancing is a crucial tool in this effort.

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