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The Last Nail in Buy-and-Hold's Coffin


You need a trading strategy uncorrelated to the markets -- or be prepared to lose years of gains.

From the 2002 bottom to the 2007 market top, it was hard to go wrong no matter what you did. Everything from junk bonds to commodities to emerging markets to the major market indices were all headed up. This made people feel they were protected from harm. It was an illusion.

Here's an interesting email from Minyan Steve, who describes his attempts to beat the averages during this period:

"I used a fee-only financial planner to evaluate our portfolio of mutual funds, using a Monte Carlo analysis tool to estimate how much we needed to save annually to hit our retirement 'number.'

"I've been a premium Morningstar member for years, and I've tried to assemble the best group of boutique funds to cover every area of the investment landscape. I used a matrix with 3 columns for Growth, Blend, and Value, with 5 rows for Large Cap, Mid, Small, Micro, and International funds.

"We held 15 funds, including all the best Morningstar performers for many years: Primecap (VPMCX), Dodge & Cox (DODFX), Longleaf (LLSCX), Fairholme (FAIRX), Artisan (ARTVX), etc.

"All of those funds performed better than the market, but not by much. To be perfectly frank, it pisses me off that I meticulously chose and invested in the best mutual funds on the planet -- and the best that they could do in 2008 is lose 35%, instead of the 38.5% the S&P 500 lost!

"It's amazing how limited they are by not shorting, being hesitant to hold large amounts of cash, and having to sell at the wrong times due to redemptions."

Diversification Isn't a Savior

Steve followed the conventional wisdom of asset allocation: Buy some mid caps, small caps, big caps, foreign equities, etc. However, Steve proved beyond a shadow of a doubt that diversification isn't a savior -- not even if one meticulously selects the best of breed.

What Went Wrong?

Diversification obviously didn't help, because everything Steve invested in was positively correlated to the major market indices. When times are good, such strategies make people feel like geniuses. Bear markets always have a way of exposing the flaws.

On an individual basis, the sad reality is that most funds simply want to beat their target benchmark. To do that, they frequently feel they must be fully invested 100% of the time. Then, by throwing out a few obvious dogs and overweighting a few top performers, managers can beat their target.
No positions in stocks mentioned.
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