Behind the Rise of ETFs

Exactly how long should a buy-n-hold investor “hold?” For example, if you held the Dow Jones Industrials Average from 1916 through 1981, would you have made money in those 65 years? Not from inflation-adjusted price appreciation.

Here are the returns:

 

 

 

 

 

 

 

The above-mentioned data represent 65 years of buy-n-hold angst. Granted, naysayers might say that the dates have been “cherry-picked” to include the Great Depression. Yet the 65-year period starts nearly 13 years before the Great Depression and ends 40 years after the start of World War 1. Indeed, it is very difficult to debate the absence of inflation-adjusted price appreciation over a period as long as 65 years.

Other hold-n-hope advocates argue in favor of dollar-cost averaging throughout the downturns. This assumes that all market participants are receiving earned and/or unearned income in excess of their necessary expenses. Unfortunately, not everyone has a store of cash on the sideline to dollar-cost average back in, regardless of how long or how deep a market falls. A great many retirees have Rollover IRAs and brokerage accounts where they are not able to put any more money to work; rather, they need the money that they currently have to secure their financial future.

Still others talk about dividends. Keep in mind that the inflation adjustment in the above data is tied to the Consumer Price Index (CPI) – an index that most acknowledge severely under-represents the erosion of purchasing power. Add to this concern the reality that 2% dividends for major U.S. benchmarks hardly compensate for the volatility and emotional difficulty associated with buy-n-hold-n-hope.

One commenter actually expressed, “It’s called buy-n-hold… not buy-n-hold forever.” The implication here is twofold. First, you should not talk about periods as long as 65 years. Second, you are supposed to sell at some point. Interesting.

Let me start with a typical time horizon discussed in the media, 30 years. Is that the magic hold-n-hope period for success? I suppose this would depend on the index as well as the country. If you wanted to use the NYSE as your broad measure of U.S. stocks, you would have struggled to maintain your purchasing power in the 30-year period from 1966-1995. If you wanted to use Japan’s Nikkei 225 at a time when the country is/was the world’s second largest economy (1984-2014), your inflation-adjusted gains over 30 years are non-existent.

Perhaps 15 years is the time horizon before a buy-n-holder would consider selling? Turn-of-the-century retirees are still battling to break even on the S&P 500 and the NASDAQ on an inflation-adjusted basis. (Once more, that is a pursuit to break if you accept CPI as your measure of inflation.) 7 years? Well, the Shanghai Stock Exchange (SSE) has watched 7 years pass by, and investors still require 160% to break even on a price basis alone. Lots of luck!

I have not even touched on the psychology. In truth, I have yet to meet the person who psychologically, and financially, felt fine with losing HALF to THREE-QUARTERS of his/her account value. Forgive those folks if they no longer embrace buy-n-hold enthusiastically.

Back to the commenter who expressed that he does not buy-n-hold forever. If you have to sell at some point, when is it? How much? Under what conditions would you sell something that you vowed to hold for the proverbial long-term? After all, it seems that leaving it to chance has not worked over 7 years, 15 years, 30 years or 65 years. From where I sit, I believe you need to have a plan to sell before you buy anything.

For example, at the beginning of 2014, I began thinning my client exposure to small-cap stock assets due to severe overvaluation. By July, several small cap stock ETFs had hit my pre-determined stop-limit loss orders. It did not matter to my clients whether I had held iShares Small Cap Value (IJS) for 5 years, 3 years, 1 year, 6 months or 6 weeks. What mattered was the fact that I would secure a big gain, small gain or small loss, simultaneously insuring against a big loss.

Some folks do not like stop-limit loss orders. Fair enough. Then learn how to apply principles of insurance to the investing process. There are a variety of ways to offer a premium (i.e., small loss) to avoid the possibility of a monstrous disaster (i.e., big loss). Some employ put options. Others may favor reducing exposure to an asset when the price of the asset pierces its long-term trendline (e.g.,200-day moving average).

Keep in mind, you can use many of the same tools to make a buy decision as well. For instance, many readers recall that I was one of the few financial professionals to suggest that rates would fall, not rise, in 2014. The contrarian call had been met with widespread scorn back in January. My message that a weakening global economy would encourage folks to seek the safety of U.S. treasuries fell on deaf ears. And the fact that yields for intermediate- and long-term U.S. debt were/are more attractive than other industrialized countries did not seem to resonate.

In contrast, trend-following investors got the message in the final few weeks of January… and they’ve been earning tremendous unrealized profits ever since. The previously maligned iShares 20+ Year Treasury (TLT) rose above its long-term trendline and hasn’t looked back.

TLT 200

When might one sell TLT? You can consider a stop-limit loss order, the 200-day trendline or inversely correlated assets. There are plenty of mechanisms for securing a favorable outcome – a big gain, small gain or small loss. Any of those outcomes are more desirable than holding-n-hoping long-term rates will be fine and dandy over the long haul.

For those who wish to stick with a “buy-n-hold” approach, perhaps you will do okay. Just be aware that history has not been as kind as many would have you believe.