Posted on July 7, 2009 by David Laidlaw
From the 1970's until the last year, there was a consensus view regarding how to manage money successfully to provide positive investment returns over time. For want of a better term, this strategy was described as “buy and hold.” The basic tenet of a “buy and hold” philosophy is to buy a diversified portfolio of stocks or funds and hold them through various market cycles to obtain the best returns for the long term. With a few caveats, this is the philosophy which guides our investment management.
The steep market losses experienced last year and during the first quarter of this year have caused individual and professional investors to reevaluate the “buy and hold” strategy. Many of these investors renounce “buy and hold” claiming that the strategy is a sure ticket to insolvency and that it is no longer a credible way to manage money. We have heard many colleagues at conferences and on Bloomberg radio declare that new “nimble” strategies with different core investments other than stocks are the only way to make money going forward.
These new strategies, however, boil down to two ideas: market timing and investing in alternative investments. Market timing relies on the ability to invest in markets (usually stocks) when prices are rising and then time the exit opportunistically so that the investor is holding cash or short positions when that particular market is falling. As we have opined in earlier commentaries, successful market timing is close to impossible since most markets rise over short periods of time. For instance, this year the S&P 500 has increased about 3%. However, the market increased by 22% in the 10 trading days between March 9th and March 23. Similarly, the market advanced 3.4% alone on May 4th. If a market timer was unlucky enough not to be invested during these 11 days, his or her portfolio would be down about 23-24% for the year. This downside to market timing and the difficulty in discerning the signals indicating whether or not to invest at a particular point in time make this strategy unappealing.
Other managers are advocating investment in alternative strategies that produce positive returns when stocks fall. Other than Treasury Notes, certain derivatives and sometimes gold, there are no other asset classes that consistently rise when equity markets crash. Still, a number of managers and advisors are attracted to illiquid investments where there is no consistent market price available. These assets are often carried at book value or purchase price since they do not trade and it is hard to determine an accurate price. However, these valuations are solely an accounting fiction and do not reflect reality. Oftentimes, an investor requires cash and is forced to liquidate his or her investments which only sell for fractions of book value. Illiquid investments look good on paper until one actually needs the cash.
Buying and holding high quality common stocks that produce positive cash flows is a proven strategy that has profited investors over the past century. The downside to this strategy is that prices fluctuate wildly and investors need to be disciplined not to sell equities when conditions are stressed. The very reason that common stocks provide higher rates of return than other securities is that these investments are risky. However, long holding periods and disciplined investment allow one to benefit from long-term returns and limit risk. Other investment strategies, such as market timing, are not new and impossible to execute profitably.