When Buy and Hold Fails

Lessons From History.

Samuel Lee 20.02.2014
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A version of this article was published in the November 2013 issue of Morningstar ETFInvestor.

Over the past 30 years, you’d be hard-pressed to find many managers who returned noticeably higher risk-adjusted returns than those of a plain-old 60/40 portfolio of stocks and bonds that is rebalanced regularly.

However, it must be pointed out that the past three decades have been a golden age for financial assets, which enjoyed three big tailwinds: low starting valuations for stocks and bonds, low and stable inflation, and robust earnings growth. From 1982 to 2013, the following occurred: The 10-year Treasury rate fell to under 3% from 15%. The cyclically adjusted earnings yield for the U.S. stock market fell to 4% from 15%. Inflation plummeted and then remained stable. Real per-share earnings grew at a rate of 3.3% annualized, well above the 2% annualized growth since 1926. Any portfolio that maintained exposure to risky assets would have done well. There has never been a period in modern history during which so many financial assets did so well for so long.

Take a broader view, however, and buy and hold doesn’t look so ironclad.

Spin the globe and point to a country. It’s likely that a buy-and-hold investor in that country’s bonds would have been beggared had they invested prior to the 1980s. According to data compiled by economists Elroy Dimson, Paul Marsh, and Mike Staunton, a globally diversified portfolio of developed-markets bonds would have earned a 0% real annualized return from 1900 to 1984. Of the 19 countries in the sample, Denmark’s 1.95% annualized real bond return is the highest for this period. This isn’t even counting taxes and fees.

Many of these countries racked up big debts from World War I and World War II. They debased their currencies, ran the printing presses, and suppressed interest rates to bring their debt burdens down. Keep in mind these were the big, largely successful countries. There were plenty of sovereigns that went bust. In the early 1900s Argentina was one of the richest countries in the world, with higher per-capita income than France, Italy, and Spain. However, it’s not in the Dimson, Marsh, and Staunton sample because it became a banana republic, a status it has maintained for nearly a century.

The most extreme case of a highly indebted sovereign paying back its debts in full is 19th-century United Kingdom, according to GMO’s Ed Chancellor.1 When the Napoleonic Wars concluded in 1815, the U.K.’s public debt as a percent of gross domestic product exceeded 250%. However, the U.K. went back on the gold standard at great social cost, inflicting a deflationary depression, and paid its debts off in full over the next century. Chancellor attributes this extreme outcome to several factors: 1) The debt was financed domestically; 2) gilt holders were well-represented in Parliament; 3) economic growth was strong. In fact, over this period, the British Empire rapidly expanded and achieved the height of its powers.

Lest you think the U.S. special, know that the government has twice inflated away the massive wartime debts it accrued during the Revolutionary War and World War II.

The widespread notion that bonds are “risk-free” or “safe” investments is largely the product of the unusually benign inflationary environment of the past 30 years. It would be a mistake to assume history won’t repeat or rhyme.

OK, but what about stocks? In “Stocks for the Long Run”, Wharton economist Jeremy Siegel found the U.S. stock market grew 7% annualized after inflation with surprising consistency. The number has been enshrined as “Siegel’s constant.” Siegel deserves credit for the widespread belief that stocks are safe if held for 30 years or more.

However, extrapolating the U.S. experience to the future is a questionable leap. Over the past 200 years, the U.S. went from emerging market to sole superpower, without losing a major war or experiencing a significant period of economic discontinuity.

Ask the poor investors who bought Japanese stocks in the 1980s or the 1930s or European stocks in the 1900s if “Siegel’s constant” or dollar-cost averaging worked out for them. They were never made whole or had to wait several decades to break even.

Some stock markets have even disappeared. In early 20th century, Tsarist Russia had one of the bigger equity markets in the world. The 1917 Russian Revolution turned stock certificates into fancy facial tissue. Russia’s stock market didn’t reopen until the Soviet Union fell nearly 90 years later. Philippe Jorion and William Goetzmann document numerous examples of countries with stock markets that disappeared at some point in the 20th century: Greece, Romania, Czechoslovakia, Hungary, Chile, Argentina, and Poland.1

Buy and hold isn’t a sure-fire recipe for preserving or growing wealth, even over several decades, nor is the contrarian strategy of buying the dips. (Outside of the U.S. and U.K., evidence of mean reversion in stock prices is weak—a beaten-down market can be broken.) History shows markets can go to zero or experience multidecade periods of low returns. Common causes include revolution, losing a big war, and expropriation. The only way a buy-the-dip or a buy-and-hold strategy makes sense for equities is if you’re confident the market you’re investing in is highly unlikely to experience a permanent loss of capital. I do think much of the rich world, with its democratic institutions, rule of law, mostly capitalist economies, and vibrant civic societies, is unlikely to experience disaster. I’m not so confident in emerging markets, which is why I would never own a 100% emerging-markets stock portfolio, even if valuations fell to rock-bottom levels.

Finally, the buy-and-hold investor is vulnerable to valuation risk. Investors who bought Japanese stocks at their 1989 peak have yet to break even. This is one of the rarer risks. Japan’s cyclically adjusted price/earnings ratio reached more than 80 at its peak, a bubble of monstrous portions. The U.S. during the dot-com bubble hit only 44.

In sum, history suggests buy and hold is a terrible strategy for bonds; the past 30 years were an aberration. Buy and hold is justifiable for stocks, but only if you’re confident the market you’re investing in is unlikely to experience a permanent loss of capital. Even then, you can still lose big if you buy at extreme prices.

1 Jorion, P., and Goetzmann, W. N. “Global Stock Markets in the Twentieth Century.” Journal of Finance, Vol. 54, No. 3. 1999.

 

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Samuel Lee  Samuel Lee is an ETF strategist with Morningstar and editor of Morningstar ETFInvestor

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