After reading a recent debate, I decided to chime in with my own thoughts on the matter. Somehow the discussion of buy and hold evoked the typical academic responses of markets being efficient and so forth.
A few comments on ‘efficiency’
Market efficiency implies that all information is assimilated into the current market price, and therefore there is no possibility that you can buy assets cheap, to then sell high, because if it was truly cheap, the market would quickly jump in to buy the security, thus bidding up the price, eliminating the opportunity. Fantastic, but is it logical? This is similar to the University of Chicago line of thinking that if there was a $20 bill on the floor, it must be fake because someone would have picked it up by now. We all know that there is a very high possibility that short term inefficiencies exist. The quant funds have all but proven it: DE Shaw, Medallion, AQR Capital are all funds that trade in liquid equity markets but arbitrage short term opportunities. A hedge fund expert wittingly referred to these funds as “excess liquidity providers”. My favorite response to anyone who says that markets are efficient is: “that is a self fulfilling prophecy” …
The Buy and Hold Debate
Buy and Hold is an “asset allocation policy” … it basically implies that the strategic asset allocation it the best guess as to what will be the best performing allocation over the investment horizon (typically 1+ years). If you do not think buy and hold works, that means you adjust the strategic asset allocation (ie shift equity weightings up and down over time) and make tactical trades (short term opportunities that present themselves in the market) to add alpha. Dynamic asset alllocation therefore, is saying that “buy and hold” doesnt work (ie “Buy and Hope” …. 
. Time varying asset allocation emphasizes that dynamically switching the asset allocation you can minimize the downside of bear markets, overweight markets that are rallying, etc. It is the holy grail of money management: “equity like returns with bond like risk”.
Due to the increased difficulty in cranking out decent returns, it is even more important to “think dynamically”.
Performance of a 70% stocks, 30% bonds Portfolio
The chart below shows how difficult money management has been. A portfolio of 70% stocks and 30% bonds (note we are using the MSCI US Stocks Index, total return, for stocks, and the Salomon Brothers US Treasury Index, for bonds) performed as follows:
- +16.6% per year from 1985-1999, with a standard deviation of 10.9%, compared with…
- +1.8% per year from 2000-2010, with a standard deviation of 11.1%
This is a huge drop in annualized values in an aggressive Equity portfolio (far below the risk free rate of return), with an elevated level of risk. The return to risk ratio was nearly 9x higher from 1985 – 19999 versus the past ten years.
Returns by Market (80s and 90s versus 2000s)
There was a huge drop in asset class returns between the two periods. further strengthenting the case for a more dynamic approach to asset allocation in the 2000s. Even bonds have fared substantially worse in the past decade than the prior 15 years.
Returns by Asset Class (80s and 90s versus 2000s)
Another asset class focused way to see the same data …
Efficient Frontier Comparison
This secular shift in returns between the different decades has produced a notable response to the buy and hold, academic oriented crowd: a notable downward push to the efficient frontier. Interpretations of the efficient frontier are as varied as how people like their eggs in the morning. Some think it is useful, others useless, some think it is a good framework, others think it is a good tool for clients to see and not much else. Regardless, it is a mathematical approximation as to the “best, most efficient portfolios using return and covariance measures”. Utilizing expected returns from these different periods, the following two, vastly different efficient frontiers were produced.
Conclusion
This is slicing the past thirty years into two periods, one when the business environment was booming and capital markets surged, and the other when the world suffered two disastrous bear markets and a global mini-Depression. Buy and Hold is a methodology that worked “before” and it is unlikely that it will work in the future. After the carnage in 2008 and 2009, portfolio managers have lowered their expectations. With the world economy still unstable and risky, investors have accepted this fact, and our view is that asset allocation has to be more imaginative and dynamic.
Tags: Asset Allocation, asset allocation software, buy and hold