Buy-and-Hold Is Dead — These Studies Prove It! (Part Two)

Buy-and-hold is dead. This page is Part Two of an article linking to 20 studies showing why.

Before taking a look at the links set forth below, please read the introduction to the article, set forth at Part One of Buy-and-Hold Is Dead — These Studies Prove It!

Study #10 Showing That Buy-and-Hold Is Dead — CJKing Graphic at Comparing P/E10 Predicted Yield with Hindsight Yield 

Juicy Excerpt #1: The measure that “q” is shown to predict very well inValuing Wall Street is called “Hindsight Value” because the goodness/badness of starting dates is exactly what it tries to capture. “Hindsight Value” is defined as the average annual return experienced by 40 investors with holding periods of 1 to 40 years respectively. The averaging across the 40 different end dates causes the effect of good and bad end-dates to cancel each other out, so the average then becomes a measure of the merit of the starting date only. When they overlay the chart of “q” on that of hindsight value, they track each other very closely.

Ciff Asness

Juicy Excerpt #2:I can’t help feeling that, if anyone looks at that chart and concludes it contains insufficient information to affect their non-valuation-based strategy, and that there’s no reason (everything else being equal) why their equity allocation should be any different in 1929, 1968 and 2000 than it was in say 1920, 1933 or 1982, then no amount of data points will change their mind.

Juicy Excerpt #3: It’s not how good or bad the starting date is in historical terms that matters, but how equities at that valuation compare to alternative investments.

Juicy Excerpt #4: I like 1/PE10 as it’s easy to understand why it should tell you something useful. One could justify using it even if one had nowhistorical return data.

Study #11 Showing That Buy-and-Hold Is Dead — Norbert Schenkler’s “Mental Exercise” at the Financial WebRing Forum 

Juicy Excerpt #1: Valuation-Informed Indexing is pretty clearly superior everywhere, although there are a few occasions ending in the last half of the 90s, i.e. starting in the last half of the 60s, where Buy-and-Hold has a small advantage [Note: These words were written prior to the September 2008 stock crash — they no longer apply]. Recent differences appear to be quite minor, although I would point out that an extra 1/2% a year over 30 years is not chicken feed.

Juicy Excerpt #2: If you ignore the right hand side and imagine you are in 1996, just as Shiller was when he began to think and argue and publish about this, the evidence is pretty incontrovertible. Valuation-Informed Indexing, i.e. market timing, is everywhere superior to Buy-and-Hold over ten year periods. An occasional time, sometimes for decades, Buy-and-Hold is close, but there are periods of serious underperformance relative to Valuation-Informed Indexing. In 1996, you could not make an argument that the historical data ever showed a period where Buy-and-Hold was better. Timing was sometimes no better but it was never worse.

Juicy Excerpt #3: But then the late 1990s happened and it all went to hell. Buy-and-Hold turned out to be a huge winner in the late 1990s. Tie it together with widespread acceptance of modern portfolio theory and efficient markets – and no looking too far back because really old history is probably less relevant – and Buy-and-Hold is obviously the way to go (Note: Again, these words were written prior to the September 2008 crash and the finding that Buy-and-Hold ended up being superior this one time in the historical record no longer applies).

Study #12 Showing That Buy-and-Hold Is Dead — Bob’s Financial Web Site on “Real Returns vs. P/E10” 

Juicy Excerpt #1: I then created scatter plots for Real Returns vs. P/E10 (the scatter plots show an r-squared of 0.61 for 20-year time-periods, an extraordinary amount of predictability for the P/E10 valuation metric — this means that close to 80 percent of the risk of stock investing is removed by looking at the P/E10 value that applies prior to making purchases).

Study #13 Showing That Buy-and-Hold Is Dead — Real, Annualized, Total Return Versus Valuations, by John Walter Russell (owner of the site)

Juicy Excerpt #1: This shows the Year 20 annualized, real, total return versus P/E10 using the years 1923 -1980.

Study #14 Showing That Buy-and-Hold Is Dead — Current Research R: The Valuation-Informed Indexing Advantage, John Walter Russell (owner of the site)

Juicy Excerpt #1: Here are some numbers based on the most likely values of P/E10 from Year 2000 to Year 2030…. The advantages of Valuation-Informed Indexing are tremendous. They are already 4%+ based on a simple Treasury Inflation-Protected Securities (TIPS) comparison at Year 10. They will be a fantastic 7.6% per year (real, annualized total return) at Year 20. They will still offer an advantage of 4.2% per year at Year 30 assuming that the correct decision is to remain in stocks.

Study #15 Showing That Buy-and-Hold Is Dead — Investing Discussion Boards Ban Honest Posting on Valuations!, Rob Bennett (owner of the web site)

Juicy Excerpt #1: Rob’s da man! Never in the history of the Diehards forum has one poster, always making civil and well-thought-out posts, managed to irritate so many without anyone being able to articulate a good reason as to why.

John Mauldin

Note: This is not the typical investment “study.” No numbers! Passive Investing is a numbers-oriented model; that’s why studies prepared under this model tend to focus on numbers. There’s a place for that. But I believe that part of the benefit of the move to Rational Investing will be a broadening of the focus of investment analyses. We need to study more than just the numbers. We need to study the role of human emotion on stock prices and on stock returns and on our beliefs about how stock investing works and on our willingness to permit honest discussion of various investment topics on the internet and elsewhere. This study is all words, the words of members of the Retire Early and Indexing discussion-board communities who favored the idea of permitting honest posting on valuation-related topics and were struggling to come to terms with the demands of a relatively small number of Passive Investing dogmatics that such discussions be banned. I believe that you will learn as much or more about how stock investing works from looking at this “study” as you will from looking at even the best numbers-oriented studies.

Study #16 Showing That Buy-and-Hold Is Dead — The Financial Crisis and the Systemic Failure of Academic Economics, by David Colander and Eight Others

Juicy Excerpt #1: The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold. In our view, this lack of understanding is due to a misallocation of research efforts in economics. We trace the deeper roots of this failure to the profession’s insistence on constructing models that, by design, disregard the key elements driving outcomes in real-world markets. The economics profession has failed in communicating the limitations, weaknesses, and even dangers of its preferred models to the public. This state of affairs makes clear the need for a major reorientation of focus in the research economists undertake, as well as for the establishment of an ethical code that would ask economists to understand and communicate the limitations and potential misuses of their models.

Juicy Excerpt #2: Many of the financial economists who developed the theoretical models upon which the modern financial structure is built were well aware of the strong and highly unrealistic restrictions imposed on their models to assure stability. Yet financial economists gave little warning to the public about the fragility of their models, even as they saw individuals and businesses build a financial system based on their work.

Juicy Excerpt #3: The corner stones of many models in finance and macroeconomics are rather maintained despite all the contradictory evidence discovered in empirical research. Much of this literature shows that human subjects act in a way that bears no resemblance to the rational expectations paradigm and also have problems discovering ‘rational expectations equilibria’ in repeated experimental settings. Rather, agents display various forms of ‘bounded rationality’ using heuritic decision rules and displaying inertia in their reactions to new information.

Juicy Excerpt #4: Paradoxically self-reinforcing feedback effects within the profession may have led to the dominance of a paradigm that has no solid methodological basis and whose empirical performance is, to say the least, modest.

Study #17 Showing That Buy-and-Hold Is Dead — Asset Allocation and Long-Term Returns: An Empirical ApproachStephen Coggeshall and Guowei Wu, Morgan Stanley

Juicy Excerpt #1: Long-term stock return distributions show strong mean reversion, with substantial consequences for long-term strategies such as asset allocation.

Juicy Excerpt #2: We can immediately see in comparing Figure 11 to Figure 10 that the standard deviation of returns, as measured directly from the data, is less than from a random walk assumption, particularly as the holding period increases.

Juicy Excerpt #3: The evidence shows that equity markets have positive autocorrelation for short times and negative autocorrelation for long time horizons, which says that trends exist for short time periods and mean reversion exists for long time horizons.

Juicy Excerpt #4: The risks of stocks are substantially less than theory suggests for holding periods of 20 years and greater.

Juicy Excerpt #5: It is not hard to understand and explain both short-term and long-term market behavior in terms of investor psychology and free markets. Short-term trends exist and can even become disastrous bubbles. Long-term mean reversion comes from business cycles, driven by the need for substantial over- or under-pricing to be washed through the system over long time scales.

Study #18 Showing That Buy-and-Hold Is Dead — Understanding Secular Bear Markets: Concerns and Strategies for Financial Planners,Kenneth R. Solow and Michael E. Kitces

Juicy Excerpt #1: Since March of 2000, it is probable that most financial planners have delivered a level of investment performance that is far below the assumptions made in their clients’ financial plans at that time, even if the planner had used ‘reasonable’ historical averages rather than the remarkable returns of the 1990s… The numbers are appalling.

Juicy Excerpt #2: It is interesting to note that the vast majority of financial planning firms were created or experienced most of their growth and development during the secular bull market between 1982 and March of 2000. Consequently, most planners have no experience managing client wealth during a secular bear market. Much of what they do know has been learned during an unprecedented period of rising stock prices and expanding P/E ratios.

Juicy Excerpt #3: Unfortunately, the facts about secular market cycles do not fit easily into the strategy of passive strategic rebalancing. Optimizer inputs that are derived using long-term average returns will not reflect the wide and significant differences in expected asset class returns during secular bull or bear markets…. Making even minor adjustments to expected returns to account for market cycles will result in dramatically distorted portfolios when run through an optimizing program. This often results in the planner “constraining” the resulting asset allocations so that they are palatable to both the client and the planner.

Andrew Smithers

Juicy Excerpt #4: If historic assumptions about equity returns are valid, then the best way to increase the return on a client’s assets is to increase the equity exposure of the client’s portfolio policy…. But in a secular bear market, the result of adding to traditional equity asset classes will not be to increase portfolio returns. Indeed, it may actually decrease portfolio returns (by increasing exposure to declining asset classes) while at the same time increasing portfolio volatility.

Juicy Excerpt #5: Using the long-term average return assumptions (particularly in a linear projection) ignores the fact that the order in which the client experiences market returns will affect success during a period of retirement withdrawals. Even if the market “averages” its long-term rates of return over the next 30 years, it won’t help if a secular bear market causes a client to run out of money after the first 15 years of retirement, having no account balance remaining to enjoy the secular bull market that would eventually follow.

Study #19 Showing That Buy-and-Hold Is Dead — GMO Quarterly Letter, July 2005 (“Explaining P/E”)Jeremy Grantham

Juicy Excerpt #1: The market has not read the basic textbooks and resolutely refuses to be accommodating. The factors that most professionals would consider the most important “fundamentals” have no explanatory power for P/E.

Juicy Excerpt #2: What does have a positive correlation with P/E shifts is any behavioral factor having to do with investor psychological comfort.

Juicy Excerpt #3: Exhibit 1 shows our model…. The fit is almost preposterously good…. Notice that this behavioral model called for the highest P/Es in history-to-date in 1929, 1965 and much the highest ever in early 2000.

Juicy Excerpt #4: All of the three factors that go into the model are still far above normal, and all three are provably mean reverting; that is to say they will go back to normal sooner or later. When all three factors are at average, the model will call for a P/E of 16. Moving to average for the most important factor — profit margins — will involve as much market pain as will the decline in P/Es. If both P/E and profit margins were at normal levels tomorrow, the S&P 500 would be at about 780, versus today’s level of 1200 plus.

Juicy Excerpt #5: Exhibit 2 shows the 10-year returns from investing at all monthly starting points sorted into five quintiles by comfort since 1925. Not surprisingly, investors have made about 10 percent a year compounded after deducting inflation when comfort was low, and only 2 percent when comfort was at its highest.

Juicy Excerpt #6: This may all seem very counterintuitive, but it is the logical outcome of living in a mean-reverting world. As mentioned in other letters, economic trends mean revert because there is a powerful and persistent normal return toward which capitalist competition strives, competing down handsome margins and P/Es and avoiding low returns until shortages develop.

Study #20 Showing That Buy-and-Hold Is Dead — Why Economists Failed to Predict the Financial Crisis 

Juicy Excerpt #1: Over the past 30 years or so, economics has been dominated by an “academic orthodoxy” which says economic cycles are driven by players in the “real economy” — producers and consumers of goods and services — while banks and other financial institutions have been assigned little importance, Allen says.

Juicy Excerpt #2: But it was the financial institutions that fomented the current crisis, by creating risky products, encouraging excessive borrowing among consumers and engaging in high-risk behavior themselves, like amassing huge positions in mortgage-backed securities, Allen says. As computers have grown more powerful, academics have come to rely on mathematical models to figure how various economic forces will interact. But many of those models simply dispense with certain variables that stand in the way of clear conclusions, says Wharton management professor Sidney G. Winter. Commonly missing are hard-to-measure factors like human psychology and people’s expectations about the future, he notes.

Juicy Excerpt #3: Says Winter: “The most remarkable fact is that serious people were willing to commit, both intellectually and financially, to the idea that housing prices would rise indefinitely, a really bizarre idea.

Juicy Excerpt #4: By relying so heavily on the view of humans as rational, the paper’s authors argue, economists ignore evidence of irrational behavior that is well documented in other disciplines like psychology and sociology…. “It is highly problematic to insist on a specific view of humans in economic settings that is irreconcilable with the evidence.”

Jeremy Grantham

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