Is 'Buy and Hold' Really Broken?

Jason Stipp: I'm Jason Stipp for Morningstar. The concept of buy-and-hold; is it outdated, out of touch, or simply misunderstood? Here with me to offer her take is Morningstar's Christine Benz, director of personal finance for Morningstar.com.

Christine, thanks for joining me.

Christine Benz: Jason, nice to be here.

Stipp: After the big market downturn that we saw in 2008, we've been hearing a lot of folks saying, buy-and-hold is dead. It's not a strategy you can follow anymore. It didn't work for investors. We have to rethink how we plan our portfolios. My first question to you: is buy-and-hold dead?

Benz: Well, I don't think so, Jason, and I do think as you and I have discussed in the past, it's a little bit of a straw man argument to suggest that anyone was saying, buy S&P 500 funds, and then just batten down the hatches for the next 10 years. Never add any money, never rebalance. Really no one was suggesting that.

Instead a better strategy would have been to dollar-cost average, so you'd be sure you'd be putting some money to work on the dips; rebalance, so you'd be periodically getting your asset allocations back into whack; and then also for everyone as we grow older, it makes sense to put more money into safe assets like bonds and cash. And so I don't think anyone was ever saying that an all-stock portfolio, a buy-and-hold stock portfolio was right for people.

Stipp: So just because the word "sell" isn't in part of the "buy-and-hold" term, it doesn't necessarily mean that you wouldn't be repositioning your portfolio and changing things around.

So I think one of the key points there is that as you grow older, naturally, the composition of your portfolio you're going to want to change, and that may involve making some sales or redirecting money as you're putting more money into your portfolio.

How do you know, though, over time how your portfolio should adjust? How should you become more conservative as you're growing more toward retirement?

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Benz: That's a big question, Jason. I think, it's what the right asset allocation is for people at various life stages is the question really that we all need to answer before we start investing. Certainly there are some benchmarks you can look to. I think, that target-date funds make it a little easier to see, well, okay, I'm 55, what is an appropriate asset allocation for someone at my life stage?

Morningstar also has some Lifetime Allocation Indexes that are powered by Ibbotson data, and those are another tool, another resource that people can look for when they're trying to benchmark their own asset allocation policy.

Stipp: So it's potentially a good place to start to get a handle on where you are and where you might want to be.

Secondly, you will make some adjustments as you grow older, but also in-between times you may be making some adjustments, you alluded to earlier, in your rebalancing process, so really it's sort of "buy, hold, and rebalance." How do you know when to undertake that kind of move in your portfolio and what triggers you should use?

Benz: Vanguard recently came out with a really helpful study that looked at specifically this question, so should you rebalance on time-period interval, say, once a year, or should you rebalance when your portfolio veers one or two or five or ten percentage points in terms of asset allocation versus its targets.

Their study ultimately concluded that monitoring the portfolio on an annual or semiannual basis is plenty and then making changes when you do see your asset allocation veer five percentage points from your target, gives you the optimal balance: it keeps costs in check because rebalancing does have costs, and it also puts some downward pressure on the risk of the portfolio without impeding its return potential too much. So, they found that that was sort of the optimal mix of hands-off and hands-on.

Stipp: So, we find the right allocation for you, and then once you get that, rebalance, if you vary from that by a certain percentage at a certain period of time.

So, you know, the other question for you then is people really did suffer in the downturn and folks who were purportedly following a buy-and-hold philosophy ended up really in a painful situation. It might seem natural for them to rethink how they are doing things.

This was a time in the market that was severe. Is it possible that buy-and-hold perhaps failed during this crisis moment but could be something that you would use longer term, or do you think that buy-and-hold did fail during the market downturn?

Benz: Again, I think it depends on how you're defining buy-and-hold. So, I think actually for people, certainly everybody was burned, everybody who had stocks lost money. But if you were in a program where you were periodically buying and putting money to work in the market, you would have bought shares at ever-lower prices, which would have helped improve your overall averages, and also diversifying not just among asset classes as we've discussed but intra-asset class. So the past decade has marked very strong performance or relatively strong performance for small caps. So to the extent that you didn't just hold the mega caps that are in the S&P 500 but also took pains to diversify in terms of size, you would have done relatively better as well.

Stipp: And conceivably, if you were allocated the right way, and you needed to draw on your investments, you would have had a portion of those investments that were in more conservative, more liquid assets, you wouldn't have to lock in those losses by selling stocks that had taken a big dip and a bit hit in the market downturn.

Benz: That's the whole concept of the bucketing concept that you hear so many planners talk about, and the basic idea is that the big bucket that you have to be concerned with is the one that holds your short-term liquidity needs. So, make sure that you have enough in living expenses carved out in that bucket, and then you can be free to let the longer-term, more volatile assets slosh around, as they will, as long as you've got your near-term living expenses covered in that main bucket.

Stipp: So last question for you, Christine, a lot of folks have been getting behind the idea of a tactical asset allocation, and this is one where instead of setting a strategic allocation based on your age, you're going to be moving in and out of asset classes as things heat up, as things cool off, to try to be more opportunistic. What's your take on this as an alternative to a strategic asset allocation?

Benz: Well, it certainly seems to represent the best of all worlds for many people. The idea is that you would really be able to jump in and jump out.

In reality, though, I guess I don't have a lot of faith in tactical asset allocators' ability to pull it off with consistency. There have been a small handful of fund managers who have been able to do it. People always point to Rob Arnott, who has certainly been very successful on his PIMCO funds.

But the fund landscape is littered with managers who have not done well. A lot of these funds have folded up shop over the years. Russ Kinnel, Director of Fund Research at Morningstar, put out a piece this week essentially saying that asset allocators haven't done particularly well year-to-date, the more tactical funds; plain old balanced funds have done better.

So I don't have a lot of faith in professional investors' ability to pull off tactical asset allocation strategies, and I get a little bit nervous about individual investors being able to do it either.

Stipp: Christine, thanks for the extra context on buy-and-hold.

Benz: Thank you, Jason.

Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.