Over 25 years of writing this column, I have often discussed the value of a static buy-and-hold asset allocation with periodic rebalancing. This means investing specific percentages of your portfolio in several asset classes (a few of which are stocks, bonds, commodities, and real estate). Then, at least once a year, you buy or sell gains or losses to readjust each asset class back to the original target allocation.
Doing this can keep you from making “the big mistake” of investing. Maybe I should say “the big, lethal, fatal, mistake” of investing.
An April 8, 2015, article in Advisor Perspectives by Lance Roberts of Streetalk Live sheds some new light on the real value of maintaining a static buy-and-hold strategy. Roberts cites data from the 21st annual Quantitative Analysis Of Investor Behavior done by Dalbar, Inc. It shows that investing in a static buy-and-hold strategy, allocated 60% to stocks and 40% to bonds, in 2014 would have earned an additional $6,830 on every $100,000 invested, compared to the average amounts such portfolios actually earned.
The Dalbar study found the average return (for both do-it-yourself investors and investment advisors) on a 60/40 portfolio from 1984 to 2014 was a dismal 2.56% a year. The average annual return of the buy-and-hold strategy was 9.68%, meaning the average investor and investment advisor left 7.12% of return on the table every year.
Put into dollars, investors and investment advisors earned about $25,000 on every million invested in the stock market. Had they simply put that million into a buy-and-hold strategy allocated to 60% stocks and 40% bonds and left it alone, they would have earned $96,000 a year. That’s a loss of $71,000 annually.
Why do so many investors and investment advisors do so poorly? The biggest reason listed by Roberts, which is supported by my own observation, is psychology. Investors exhibit behavioral biases that lead to poor investment decision-making. Dalbar listed nine irrational investment behavior biases that reduce returns and found two of them were the most significant: the “herding effect” and “loss aversion.” It’s human nature both to want to follow what everyone else does and to be afraid of losing what we have. Taken together, these can lead to investing disaster.
Roberts explains that as markets rise, investors come to believe that “things are better” and the current upward trend will continue indefinitely. The longer the trend lasts, the more ingrained this belief becomes. Eventually, the market enters a euphoric time of price increases when the last of the unbelieving holdouts finally buy in.
When the market inevitably declines, investors first view the dips as buying opportunities. As markets drift lower, there is a slow realization that the decline is something more than a “buy the dip” opportunity. As losses mount, fear of loss increases until investors can’t stand the heightened feelings of anxiety and seek to avert further loss by selling. This whole process results in most investors “buying high/selling low” and runs counter to the buy low/sell high investment rule.
Put in more basic terms, the reason most investors and advisors do so poorly is they try to “time” or beat the market. The study found that while most investors and advisors guess right 67% of the time, they were not able to come close to equaling a buy-and-hold strategy.
What can you do to keep from sabotaging your own investment strategy? It becomes imperative to put a system in place which will make it difficult for your brain to panic in a downturn. Next week we will explore some options for such a system.