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Beyond Buy-and-Hold Investing

Diversification and prudent asset allocation are still important.

Veena A. Kutler and Annette F. Simon, 07/23/2009

This monthly series of articles describes the many steps and occasional missteps we have taken in building our financial advisory business, Garnet Group LLC. Currently, Garnet has eight staff members, more than 90 clients, more than $200 million in client net worth under advisement, and offices in Bethesda, Md., and Boston. Veena Kutler, CFA, and Annette Simon, CFP, are the managing principals in the Garnet office in Bethesda.

Last month we wrote about the 2009 NAPFA national conference in Washington, D.C. As we mentioned, many of the hallway conversations during that event focused on whether a buy-and-hold strategy works in today's economy and if it is time for advisors to move on to other investment approaches. It seems it's not just the advisors at that conference who are interested in this topic! We have also heard from a few readers who were asking the same questions about alternatives to buy-and-hold. Over the same time period we have discussed this topic with several of our clients who have questioned us about our investment philosophy and asked us to clarify just what we will or won't do to protect their assets in a downturn.

Given this seemingly high degree of interest, we thought a timely topic for this month's column would be our investment philosophy.

Investment Philosophy and the Markets
Our investment philosophy is based on diversification and appropriate asset allocation. Diversification to us means a broad mix of asset classes and securities. Our typical client portfolio holds 12-15 mutual funds. Underlying those funds are thousands of securities across multiple asset classes, helping to diversify away single company risk as well as single industry and asset class risk.

In terms of process, we determine each client's appropriate asset allocation by combining their return needs (based on cash flow planning) with their risk tolerance and preference, which are determined using both quantitative and qualitative measures. Once a client has agreed to the recommended asset allocation, we strongly encourage him or her to stick to that allocation over time unless something has changed in his or her underlying financial circumstances - regardless of market performance and world events. In order to maintain a relatively constant asset allocation, we typically rebalance to the model on a quarterly basis.

How does this strategy work in volatile markets?
In a volatile, but generally upwardly trending or flat market, this strategy works very well. Periodic rebalancing enhances returns by selling assets that have risen relative to those that are being purchased. Moreover, by sticking to allocations, clients avoid the whipsaw massacre caused by emotion-driven selling as markets fall and buying as they rise.

How about sharp and prolonged downturns such as the recent one we have experienced?
Markets plunged in the fall of last year and again early this year--the S&P 500 plunged nearly a terrifying 60% in a few months' time. The diversification benefit provided by asset allocation usually doesn't protect the portfolio as well during short periods as it does over full market cycles--especially during periods when every, or even most, asset classes are collapsing. This was certainly the case in the latest downturn. Small caps, mid-caps and large caps all fell, as did growth and value equities. With the rise in the dollar, international non-dollar-denominated securities declined dramatically when translated back into dollars. Many commodity prices including oil dropped, negating the benefit of commodities diversification. Bonds, which typically form the cushion of a portfolio, showed mixed results. Treasuries increased in price, but other securities including agencies, corporates, mortgage-backed, asset-backed, and municipal securities experienced spread widening resulting in price declines.

What's an Advisor to Do?
Recently a client told us that he felt that he had looked into the abyss back at the low point a few months ago and wasn't sure that he could handle it again. He wanted to know what we were doing to protect our clients going forward. Just saying that we were sticking to our strategy wasn't good enough. Other clients have expressed similar concerns. How many of you have heard these kinds of questions recently? We're guessing most of you.

Erring on the Side of Conservatism
Here's our response:

* Our goal for our client portfolios is to lose less than the broad market when prices are declining and to keep pace in rising markets. We don't want home runs and aim instead for a steady diet of singles with a few doubles. This is a conservative strategy and we are fine with that. We believe most individual investors achieve better long-term results with this approach and our clients' experiences have borne this out.

* We try to limit risk with the defensive elements of our portfolios. We have long used bond funds rather than individual bonds for the defensive, fixed income portion of our client portfolios.

Other advisors have questioned this strategy pointing out that it is possible to pick up yield by structuring individual bonds into a laddered portfolio rather than relying on funds. Two of the advisors in our Bethesda office (Veena and Laura) are former bond managers and traders who agree that individual bonds may add a small amount of return in normal markets, but can be killers in down markets and thus are generally not appropriate for smaller, non-institutional portfolios. This has been exactly the outcome during the recent downturn. Many individual bonds--including bank names, CMOs, and auto company issues--sank like rocks and were difficult and/or impossible to sell. Some of our colleagues were caught with formerly high quality holdings that were sinking and (since they were odd lots) extremely difficult to trade. Bond funds investing in the same types of assets weren't immune, but diversification, larger asset pool size, round lots and institutional management helped cushion the blow and increased the liquidity of the funds' holdings.

* We emphasize the value of appropriate asset allocation each time we meet with or speak to a client. As a rule, we encourage them to go with a more defensive allocation that allows them to sleep at night rather than shooting for a more aggressive allocation.  In our initial asset allocation meeting and in each of our on-going review meetings, we show our clients the historical downside risk (the worst one-year performance) of their current allocations. This helps them understand the potential magnitude of downturns and sets realistic expectations about performance. Since we have adopted this practice, we have not had clients telling us that they didn't know that negative results were possible with their allocations. And even during the worst of 2008 and 2009 most of our clients have acknowledged that while they don't like losing money, we have done what we said we would do with their portfolios.

* With this and during every extended market downturn, we hear anecdotally of advisors who moved all client assets to cash and who saved their clients a bundle. There is no denying that market timing is valuable if done correctly. However, to our knowledge, no has been able to devise a consistent and predictable way of timing the markets. The advisors who pulled clients out of the market are likely still sitting in cash and missed the strong rally that began at the end of March, or jumped back in late in the game. The more we work in the markets, the more we believe that consistent asset allocation based on long-term cash-flow planning is the best strategy for most individuals.

* Going forward, we are incorporating some elements in our strategy that are a step away from rigid asset allocation. Recently, applying the research capabilities of our custodian and third-party manager SEI, we moved the fixed income portion our lower risk client allocations into higher quality fixed income. This will preclude lower-risk portfolios from participating in strong rallies of corporate bonds--such as that exhibited by high-yield bonds in 2009. But we are willing to forgo that benefit in order to reduce risk in down markets. We also think some small tweaks within the asset allocation range are acceptable. This can include delaying rebalancing rather than doing so strictly by calendar, or changing the mix of growth to value or small to large within the equity portfolio by a few percentage points to take advantage of the market cycle.

But the bottom line is this: Diversification and appropriate asset allocation continue to be the cornerstones of our investment philosophy.

Periods of disarray in markets can often be a blessing in disguise for advisors. They allow us to examine and refine our investment philosophy and strategies and lead to extended conversations with clients about their true risk preferences. Have you made any changes to your investment strategy as a result of the market changes in 2008 - 2009? Write to us at DC@garnetgroup.com and tell us about it. We may publish your thoughts in an upcoming column.

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