Why Buy and Hold Makes Sense, at Least for Some of Your Investments

By Max Isaacman  MAY 03, 2013 10:00 AM

Plus: Where to look for outperformance.

 


The global economic outlook has gotten murkier; no longer does the outlook appear assuredly sanguine. The premise that the US has had its recession and that now the economy and the markets will advance seems to be not so certain. Bearish sentiment has risen and inflows into broad market ETFs have lessened. An investor has to make a decision, as usual, as to whether or not to be in the market. History suggests that it is better to be in the market because to be out of the market is betting against the odds; over the last 100 years or so, the market has ultimately moved higher. And the thing is to be in the market every day, rather than just guessing trends on a short-term basis.

In my book Winning with ETF Strategies (FT Press, 2012), I showed the results of investing $1.00 in the S&P 500 Index (INDEXSP:.INX) in 1966 and what the return would be over a 40-year period in three different scenarios:
The buy and hold strategy would have returned $16.58, which is a decent amount. If you had missed the five best days each year, you would have had a very poor return, with only $.11 left on the invested dollar. But if you had missed the worst five days each year, you would have had a great performance, the $1.00 being worth $2,520.94.

There are also big differences in the performances of each year. For instance, 1987 was essentially a flat year. But if you had missed the five best days, you would have been down about 20% that year; if you had missed the five worst days, you would have been up about 60%. In 1975, the market was up over 31%, and without the best five days, an investor would be up only about 18%.  Without being in the market on the five worst days, an investor would be up almost 46%.

Forecasting when to invest in the market on a daily basis is much more granular than forecasting on a trend basis because big gains and losses, which change portfolio performance drastically, can both come during one day. You can be right on a major market trend basis, and sell out all or part of your positions for a few days, and have your performance lag because of what happens on a daily basis.

One reason that this information should be considered when investing: If you are out of the market on the good days or some of the good days, your performance will suffer -- and no one knows when the good days or the bad days will be. So if you cannot consistently be in the market on the good days, or be out of the market on the bad days, then it is best to be long stocks for that amount of capital you can reasonably invest and want to invest. And if you are long, then you want to find the asset classes that have the best chance of performing.
How to Outperform the S&P 500 Index

The S&P 500 Index is a cap-weighted index, and there are many proponents of investing in other than cap-weighted indices. There is a perceived risk in tying index weighting to market price; at the least, this can make an index inefficient on the upside. If you are using the S&P 500 -- the most widely used benchmark -- as your benchmark, then the more you deviate from this index, the greater the chance there is of outperforming it, but also the greater chance there is of underperforming it. 

A way of looking at the market is that the market is a zero-sum proposition, meaning that there is only so much gain available, and that for you to profit in the market, another investor must lose. A zero-sum game is a situation in which each person’s gain or loss is exactly balanced by the losses or gains of the other people in the game. When the gains of people are added up and matched against other people’s losses, they sum to zero. In other words, there is only so much pie to go around; if someone takes a bigger slice, the other or others must take a smaller slice or smaller slices. So if the market is judged against a benchmark such as the S&P 500, to outperform an investor must invest in other than the S&P 500 stocks and weighting. The most usual ways to attempt to beat the market is to invest in sectors, weighting methods, or cap sizes that will outperform.

Looking for Outperforming Asset Classes

One place you can look for possible outperformance is in foreign stocks. WisdomTree, the dividend-weighted and other non-cap weighted index ETF maker, is of the opinion that Asian stocks, as defined in as the MSCI AC Asia Pacific ex-Japan Index, are in a sweet spot as far as anticipated forward returns. Based on its studies of historical valuations of Asian equities, the company concluded that Asian equities are selling at relatively low valuations based on past ranges. WisdomTree broke down dividend yield periods from these stocks into three time periods: low-dividend yield years, mid-dividend yield years, and high dividend yield years. They found that the performance for the year following the middle 12-month dividend yield time has been the highest. The year after the middle dividend years returned on average 30.86%, which is more than 17% ahead of the average for years after the other dividend years.

As of February 2013, Asian equities had a trailing dividend of 2.85%, which placed them in the middle dividend year class. Using this formula, the next 12 months could be an outperforming time for this asset class. The WisdomTree Asia ex-Japan ETF (NYSEARCA:AXJL) sells at about 13 times earnings, pays a dividend of 3.3%, and exposure to Australia, Hong Kong, and Taiwan make up over 50% of the index.

Editor's Note: Max Isaacman is the author of Blizzard of Money, Winning with ETF Strategies, Investing with Intelligent ETFs, How to Be an Index Investor, and The NASDAQ Investor.
Max Isaacman holds AXJL at the time of this article's posting.