Since the crash of 2008, many investment advisers and financial
commentators pronounced that 'buy and hold' is dead. At the lowest
point, the S&P500 fell as much as 50%, and even today most
portfolios never recovered from the fall experienced by domestic and
international markets, which both appeared to fall in sync. Worse yet,
several high quality bond funds fell by a significant amount, prompting
investors to abandon an asset generally regarded as being safe. These
events led to the assertions that buy and hold is no longer a valid
investment strategy. Active asset allocation was the new investment
strategy, and being nimble as well as having the ability to predict
which asset class will outperform in the future was the new skill to
have. Is 'buy and hold' truly dead or are the practitioners to blame for
their own failures?
Prior to the crash of 2000, it was generally
believed that the best way to get market-beating returns was to hold a
handful of well-known dividend paying stocks with good balance sheets
and a high growth potential. To find the right stocks, one had to study
the balance sheets and financial information as well as to evaluate
numerous measures based on company financials. Once the work was done,
buying and holding was the key to success. If the stocks fell, the
advice was to buy the dips. Unfortunately, this strategy fell apart just
as the market started crashing in early 2000. Most of these stocks fell
50% or more, and some fell even lower. Many companies failed or got
bought out. In hindsight, it was suggested that the price to earnings
ratios were too high, and that the market was grossly overvalued, but at
the highest point almost every single company's multiples were higher
than historical average, though very few experts suggested that this
meant to stay out of the market altogether. Nothing prepared advisers
for such a calamity, and in a desperate effort to get out from under the
falling markets, many cashed out their portfolio, just like countless
other investors. Many of the stocks never recovered in the following
decade, and some went even lower. So, 'buy and hold' seemed to have
failed.
Or did it? Several investment managers were able to make
it through the storm while holding a globally diversified portfolios of
mutual funds. Their claim was that all one needed to do was to design a
portfolio using Modern Portfolio Theory (or MPT), and then all would be
well. Was MPT the magic recipe for portfolio management? I set out to
learn the secrets of MPT by studying the course material of several
openly available MIT graduate level courses on investment management. It
was perfectly logical that MPT proponents would use 'buy and hold' as
their investment philosophy. The MPT states that diversification can be
attained by holding a basket of uncorrelated asset classes. According to
MPT, diversification provided risk management which would in theory be
able to soften the crashes like the one that happened in 2000. Not only
does MPT provide risk management, but it also provides for excess
returns (or returns higher than those of a risk-free asset such as
treasuries) based on historical returns of each of the underlying asset
class. This sounded exactly what I was looking for. No more worrying
about how to select individual stocks, and a method to manage portfolio
risk was a definite bonus. This meant getting into hundreds of stocks,
but it could easily be accomplished with mutual funds. Several Nobel
Prizes were awarded for the MPT, and it was well developed
mathematically, with many theorems and proofs that were relatively easy
to follow. Everything was consistent, and seemingly bulletproof.
Backtesting showed that diversification worked very well during the
crash of 2000, and a properly diversified portfolio held steady, barely
losing anything during the time when most people lost their shirts. This
approach called for a fairly static allocation that changed with age,
and the allocation to stocks was based on risk tolerance of the
individual investor. For most advisers, MPT was like gospel, and hardly
anyone questioned its validity prior to the crash of 2008.
Not
everybody in the investment industry was convinced that MPT worked. The
world of investments changes rapidly, yet it appeared that MPT was never
seriously challenged since it came about in 1950s. For a theory that
appeared to have such staunch backers, even mild criticism was something
worth investigating, so I began reading the literature critical of MPT
to see if there was anything behind it. The year was 2006, the stock
market was going up, and no worries appeared on the horizon. The logic
of MPT practitioners went like this. Do you have a high risk tolerance
(and many people do when the stocks are going up)? No problem! Put all
of your money into a diversified portfolio of stocks, and forget the
bonds. Who needs bonds anyway? Bonds don't grow much, yield little, and
are nothing more than ballast. Besides, the industry pays a lot more to
sell the stock funds than the bond funds. Just double up on stocks -
diversification will do its job, just like it always did. Everybody was
using MPT, and even institutions used it to gauge risks of their own
portfolios. But something didn't add up. MPT is based entirely on Normal (or
Gaussian) distribution known as the Bell Curve, which implies that
large market moves are very rare, and extremely large market moves can
not ever happen. The only problem with this was that these moves not
only happened, but they happened all the time and their effect was
exactly the force that was crushing portfolios left and right. But in
2000, many diversified portfolios survived, so nothing could have
prepared the investors for the crash of 2008, when every portfolio,
regardless of how diversified, plunged with the markets. After years of
such market turbulence, which became progressively worse after 2000,
even the most seasoned investment advisers all but gave up on 'buy and
hold' and MPT. But was MPT to blame? Upon a closer look, it appears that
the entire theory of MPT is based on several assumptions which are not
always true. So what, one could ask? The answer to that question lies in
an obscure paper of Benoit Mandelbrot.
I've always known Benoit Mandelbrot
as the mathematician who popularized fractals. However, in 1962 Mandelbrot
published a seminal paper that had long remained forgotten primarily
because it was at odds with the views of investment establishment. Only
relatively recently the points Mandelbrot raised as far back as 1962
started to be taken seriously. In "Variation of Certain Speculative
Prices" Mandelbrot has shown that cotton prices behave nothing like the
Normal distribution would predict, and instead they exhibit highly
chaotic and much more extreme behavior consistent with another
distribution - what is called Stable Paretian Law, which comes from a
family of scalable power laws. Over the next several decades, Mandelbrot
expanded this work into a theory called Multifractal Model of Asset
Returns. Without getting into the details, the implication of this
discovery would deliver the first crack in the foundation of the MPT. If
the world was less Normal and more Stable Paretian, MPT did not hold. A statistician from MIT's Sloan School Paul Cootner wrote in 1964:
"Mandelbrot,
like Prime Minister Churchill before him, promises us not utopia but
blood, sweat, toil and tears. If he is right, almost all of our
statistical tools are obsolete . . . Surely, before consigning centuries
of work to the ash pile, we should like to have some assurance that all
our work is truly useless."
Having discovered Mandelbrot's contribution to finance, it wasn't long before I found Nassim Taleb,
the famous commentator and the author of "The Black Swan" who considers
himself to be Mandelbrot's disciple. Eventually it became clear that
the missing link in the 'buy and hold' concept was proper risk
management - not the traditional understanding of risk as dictated by
the Modern Portfolio Theory, but the risk management paradigm that comes
from understanding the nature of Taleb's Black Swans and Mandelbrot's
Mild and Wild randomness, with the two extremes described by the Normal
distribution (Mild) and scalable power laws (Wild). Thus, MPT may be
'correct' most of the time, but when it fails, the failure is so
spectacular that it is justified to consider MPT a total failure. As
Nassim Taleb put it, "It does not matter how frequently something
succeeds if failure is too costly to bear."
There is one big issue
with Mandelbrot's mathematics as far as practical application is
concerned. There are neither tools nor easy to implement formulas which
can make investors lots of money, at least not yet. The math simply
tells us that we underestimate by orders of magnitude the real risk of
investing in the markets. Thus we are left with more questions than
answers. To solve this dilemma, Taleb recommends using the 'negative
knowledge' approach instead of using a prescriptive approach that is
generally practiced. Instead of claiming knowledge without having any
idea as to the confidence of that knowledge, Taleb recommends simply
avoiding the areas where our knowledge is lacking substantially,
especially when dealing with the products and markets where the risks
are routinely underestimated and where failure can be costly. After we
admit that we can not estimate risks with any degree of confidence,
Taleb's recommended approach is to be as conservative as possible with
most of your portfolio, while taking wild risks with a small portion of
it. Taleb recommends having as much as 90% of your money in CDs or
guaranteed securities (such as Treasuries) while keeping 10% in high
risk out of the money options, which are very often mispriced because of
general misunderstanding of risks by the financial establishment. While
this may work for a select group of high net worth individuals,
somebody whose portfolio is mostly concentrated in a 401k will probably
not be able to implement this approach. A similar approach can be
implemented in a 401k without taking nearly as much risk in the 'risky'
portion of the portfolio. The key is to disregard the traditional advice
about allocation to stocks vs. bonds, and to allocate much less to
stocks and much more bonds, as well as to select your investments
carefully with an eye towards hidden risks and transparency.
Now
that we know that markets are turbulent and that risk is severely
underestimated, what are the implications for the traditional 'buy and
hold' approach, and what was wrong with the 'naive' approach to 'buy and
hold' practiced by most MPT believers? The lesson is that holding a
small number of stocks does not lead to diversification. A portfolio of
1000 stocks is also not diversified when invested in a single sector or
country. Even holding every stock in the world will not protect your
portfolio from large and sudden crashes. Sometimes diversification
works, and sometimes it does not. But when it fails, the failure can be
spectacular. One conservative diversified and balanced model
portfolio (with 50% invested in fixed income) that actually had a small
gain from 2000 to 2002 when most investors were losing their shirts had
actually fallen as much as 25% when the S&P500 fell 50% in 2009.
While this may be a relatively good result, somebody with their entire
savings in such a portfolio will not be very happy. The markets later
recovered, but the lesson from this is that any investment in stocks is
riskier than most realize. Because the losses are sudden and large, it
only takes a single big loss to derail the plans of many investors. It
may never be possible to bring that money back, since it could take more
time than investors have available, and there is no guarantee that
future returns will make them whole again. The conclusion from this is
to have no more than a fraction of your money invested in stocks at any
one time. This may sound as overly conservative, but it only takes one
crash to lose a big chunk of your portfolio. If this happens when you
have already retired and are not contributing any more to your 401k, you
may be in trouble.
The lesson for the 'buy and hold' investors
are clear, thanks to Mandelbrot and Taleb. Diversify as widely as
possible and always be more conservative than the experts recommend
simply because the markets are much more turbulent than is traditionally
believed. 'Buy and hold' does not guarantee a good result by itself -
the recipe is to control portfolio volatility by limiting exposure to
asset classes whose behavior can at times be chaotic. Though it is
counter-intuitive, minimizing portfolio volatility will lead to more
consistent returns in the long run given the realities of the markets,
and while we still don't know much about how the markets work, sticking
to to what we do know and limiting our exposure to the effects of what
we don't know is a worthwhile risk management strategy.