We have been in the midst of a debate as to the benefits (or not) of a buy-and-hold investment methodology. Barry Ritholtz at the Big Picture highlights some recent research showing that some portfolio managers are able to exploit macroeconomic data to outperform their benchmarks. What hasn’t worked has been an equity-centric buy-and-hold approach. Ritholtz writes:
Cash has beaten stocks for the past 10 years; Even worse, Bonds have beaten Stocks since 1966. To me, this suggests that an active asset allocation program (rather than pure market timing) is the way to go for most high net worth investors.
Ritholtz believes that the financial industry is wedded to buy-and-hold in that it works out best from their own business perspective. However the path to active returns is tougher than it appears at first glance.
William Bernstein has noted that only a tiny fraction, 1 in 1000, investors have the skills to become truly competent investors. Let’s discount that figure and say 1 in 100 or 1 in 10 people have the ability to become good investors. If that is case, how does somebody figure out if they are in that small minority?
In short, very carefully.
Eric Falkenstein at Falkenblog has a post that takes a look the process investors should use to develop and test an investment methodology. The point being that many active investors don’t invest with any kind of plan (written or unwritten). He writes:
If you are going to invest this way, the best thing you can do is work out a system. Develop rules, test them, write them down, and at the end of the year, evaluate your results. If you fail, perhaps give it another year. But after a few years, if you underperform standard benchmarks (eg, the SPY ETF), then either get out of the market, or stop trading, an simply invest in the SPY.
Falkenstein writes in more detail on how one might test a quantitative strategy or keep track of a fundamental process. The important thing being that you avoid an ad hoc decision stream that provides you no meaningful feedback on your investment acumen. The point being that this will help you decide whether you should be using an active strategy in the first place. To wit:
Remember, odds are you will fail as demonstrated by the fact that most retail investors do not outperform the market, and neither do professional money managers. Do not assume that simply trying hard, or wanting it, are sufficient, because every money manager really wants to outperform, and most work quite hard.
After some time (and bad experiences) some investors will come to feel that an active approach is not the right for them. James Picerno of the Capital Spectator believes that two rules can help any investor let alone one who is not expecting to materially outperform the indices. Picerno writes:
The world is filled with recommendations and research on what works best in the money game. But when you reduce the sea of study down to the essential lessons, we’re left with rule number one—diversify within and across asset classes, i.e., asset allocation—and number two—rebalance.
It is easy to complicate your investment life. The temptations are always out there, especially those that tap into our desire to hear unlikely stories of simple paths to success. Picerno again:
In short, Pay close attention to designing and managing the asset mix. Much of the world practices a far more complicated form of money management, but that doesn’t mean that greater complication leads to better results.
Investing isn’t easy. Even a streamlined process focused on asset allocation and rebalancing requires a series of decisions, each of which can be second-guessed in retrospect. What investors can’t do is keep kidding themselves that they have a viable alpha generating process when all they are doing is investing by the seat of their pants.