Crazy Talk

Not Thinking Straight
The worst investment thinking comes at market extremes. The nuttiest period in my 30-year investment memory was the peak of the New Era, in 1999-2000. "Dow Jones 36,000" was a best-seller. Morningstar technology analysts received death threats for downgrading stock ratings. The 80-year old mother of a senior Morningstar executive loaded up on CMGI, an Internet bubble company that lost 99% of its value over the next two years.

The next silliest is today: The Great National Funk. This, too, came courtesy of a stock-market extreme: the 2008 market crash, which gave the S&P 500 its biggest calendar-year loss in 77 years. Once again, the sheer size of the market's movement, like a power surge to an appliance, or a tidal wave to a retaining wall, overwhelmed the senses. It shorted circuits, overflowed barriers, battered rationality. The New Era inspired giddiness and greed; The National Funk brought anxiety and fear.

This led to the widespread idea that strategic, buy-and-hold, investing was an outdated concept. The notion spread throughout the investment community after 2008, promulgated by Wall Street investment strategists, money managers, and personal-finance writers. This time, we were told, things were different: The buy-and-hold strategy that worked in the past would not work in the future.

(See here, here, here, here, and here. Feel free to google for hundreds more.)

This was a claim based on emotion. It was hatched from The National Funk and was sold into The National Funk. In reality, the investment conditions of 2009 were no different than those of years before. It's true the economic news was much less pleasant. Stock prices were much lower, the country was in a recession, and there was even the fear of another depression. These things shall pass. Economic cycles occur, and stocks sometimes get hammered.

It's also true that 2009 looked very different in the rearview mirror. For the first time in decades, the trailing 10-year return for stocks lagged that of cash and bonds. But again, these things come and go. There is no ironclad rule that risky assets will outperform safer assets over every rolling decade. Sometimes they don't. No matter. How the numbers land should not affect investment policy. It makes no more sense to doubt the wisdom of buying and holding stocks when at an unfavorable endpoint for stock returns than it does to decide to own more stocks at a favorable endpoint.

Finally, there was the New Normal argument, as advanced by PIMCO and Bill Gross. The main prediction of the New Normal was economic: The U.S. economy would not roar out of the 2008-09 recession, as is expected during recoveries, but would instead trudge along at only a modest pace. That analysis was spot-on and has earned PIMCO much-deserved credit.

The secondary prediction of the New Normal concerned investments: That stocks would have a lower rate of return in the future, and that stock investors would not automatically succeed by buying on dips. That analysis has been wrong--very wrong. Stocks have had a spectacularly high return since Gross wrote those words, and buying on the few dips has been profitable indeed. In short, 1) the New Normal thesis never directly said that buy-and-hold is dead, and 2) even if it did, nobody should overhaul an investment approach based on the stock-market predictions of a bond economist.

There never was any logic behind the "buy-and-hold is dead" argument. Might it have lucked into being useful? Not a chance. Coming off the 2008 downturn, the U.S. stock market has roared to perhaps its best four and a half years in history. It has shone in absolute terms, posting a cumulative gain of 125% since spring 2009. It has been fabulous in real terms, with inflation being almost nonexistent during that time period. It's been terrific in relative terms, crushing bonds, cash, alternatives, and commodities, and by a more modest amount, beating most international-stock markets as well. This is The Golden Age. We have lived The Golden Age, all the while thinking it was lead.

To put the matter another way, those who left stocks for bonds, cash, alternatives, or commodities following 2008 have lost roughly the amount of their original investment in opportunity cost. That is, a $10,000 investment in U.S. stocks in January 2009 would be worth $22,000 today, as opposed to $13,500 for the typical intermediate-bond fund, and between $10,500 and $13,000 for cash, alternative, and commodities funds.

Critics will respond that mine is a bull-market argument. That's backward. "Buy-and-hold is dead" is the strategy that owes its existence to market results. It only appears after huge bear markets, and it only looks good after such markets. It is the oddity, while buy-and-hold is the norm.

The reason that buy-and-hold is the norm is that it's deucedly difficult to implement anything else. As outlined in Tuesday's column, three professors recently concluded that even a fully rational investor who follows an optimal trading strategy, making errors neither of emotion nor math, can't outgain buy-and-hold stock investors when using real-time data (as opposed to studies that show above-market results because of hindsight bias). For real-world investors who are probably imperfect, the news gets even worse.

"Buy-and-hold-is-dead" doesn't have the force of logic. It doesn't have results. It is opposed by Jack Bogle, Warren Buffett, and nearly everybody in the academic community. It is a bad investment idea that deserves to expire.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.