This article is based on a recent discussion between Morningstar director of personal finance Christine Benz and Morningstar.com editor Jason Stipp.
After the big market downturn seen in 2008, a lot of investment voices have been saying that buy-and-hold is dead, that it's not a strategy you can follow anymore, that it didn't work for investors, and that we need to rethink how we plan our portfolios. But is the concept of buy-and-hold outdated or simply misunderstood? We think it’s the latter rather than the former.
No one was ever suggesting that you should buy equity funds and then just batten down the hatches for the next 10 years—never add any money and never rebalance. Instead a better strategy would have been to pound-cost average (to put some money to work during the dips) and to rebalance (to periodically get your asset allocations back in order). In addition, as an investor gets older, it makes sense to put more money into safe assets like bonds and cash and less into equities. Just because the word "sell" doesn’t appear in the term "buy-and-hold", it doesn't necessarily mean you wouldn't reposition your portfolio and change things around. No one was saying that an all-stock, buy-and-only-ever-hold portfolio was right.
Buying, Holding and Rebalancing
One of the key points here is that as you grow older, you’re going to want to change the composition of your portfolio, and that may involve making some sales or redirecting money as you inject more into the portfolio. The big question is how do you know how to adjust your portfolio over time, i.e. how should you become more conservative as you grow closer to retirement?
What is the right asset allocation for people at various life stages? This, really, is the question that we all need to answer before we start investing. Certainly there are some benchmarks you can look to. Target-date funds can make it a little easier to identify whether your asset allocation is in the right ballpark for your age range (you can search for target-date funds in Morningstar’s Fund Quickrank). Of course, there are no one-size-fits-all asset-allocation solutions—none of us knows how long we'll live, for one thing--and these funds can vary widely in their asset allocations and in their overall quality, but they can also be a good starting point for your asset-allocation framework. Target-date funds aren’t the only option for true long-term investing but looking at their asset allocation can be a good place to start to get a handle on where your portfolio is and where you might want it to be.
As alluded to earlier, it’s really a "buy, hold and rebalance" strategy that we’re talking about, but knowing when to rebalance and how are key. Vanguard recently published a helpful study that specifically looked at this question: Should you rebalance on a 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 and making changes when your asset allocation veers five percentage points from your target gives you the optimal balance. This strategy keeps costs in check—it’s important to remember that rebalancing does have costs—and it also puts some downward pressure on the risk of the portfolio without impeding its return potential too much. Vanguard found that this was the optimal mix of hands-off and hands-on.
Buy-and-Hold in a Downturn
The critics of buy-and-hold will tell you that investors purportedly following such a strategy during the downturn ended up in a rather painful situation and that therefore, during crisis time, buy-and-hold failed. Certainly everybody who held stocks during the financial crisis lost money, but if you were in a programme 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. Further, diversifying not just among asset classes but also within asset classes would have also helped to smooth out volatility levels. For example, the past decade has marked a relatively strong performance for small caps, so if you had diversified within equities and didn’t just hold the mega caps that are in the FTSE 100 but also took pains to diversify in terms of size, you would have done relatively better. Similarly, if your allocations were in order and you needed to draw on your investments during the downturn, you would have had a portion of your investment portfolio in more conservative, liquid assets, meaning you wouldn't have to lock in losses by selling stocks that had taken a big hit.
This is the concept behind the “bucketing approach” that financial planners sometimes talk about. The idea is that the ‘bucket’ that you need to be concerned with is the one that holds your short-term liquidity needs—you need to make sure that you have enough in living expenses carved out. Once you've got this bucket covered, you will be able to let the longer-term, more volatile assets slosh around, as they will.
Tactical Asset Allocation
Tactical asset allocation is a concept that’s increasingly been gaining attention. The idea being that instead of setting a strategic allocation based on your age, you allocate funds to specific assets as the investing environment heats up or cools off, i.e. you try to be more opportunistic. At face value, it may seem to represent the best of all worlds for many people: you can jump in and jump out as the environment dictates. In reality, however, there are question marks over how successfully tactical asset allocators can consistently pull it off. There has been a small handful of fund managers who have been able to do it—people often point to Rob Arnott, who has 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, published an article earlier this week showing that the more tactical asset allocators have not done particularly well year-to-date; plain old balanced funds have done better.
If you find yourself questioning whether professional investors are able to pull off tactical asset allocation strategies, you’re also likely to get a little nervous about the prospect of individual investors being able to succeed.
