Investment strategy: buy and hold still works 20 April 2009
The JSE is off its lows of November 2008. Has the worst passed? Are we on the road to a recovery? Are there pockets of value? Should we buying or selling?
I have heard all these types of investment strategy questions recently, and my advice is consistent: whereas short-term value can be made by attempting to time the market, it is not the answer to long-term value creation. Sticking to a well-considered, long-term strategy is the true answer to wealth creation.
What creates long-term value? Fund performance or investor behaviour?
Surely it’s fund performance, because without performance, there is no value creation?
While this is true in the short term, the trick to long-term value creation is devising an investment strategy that fits your requirements, and then sticking to it. Value destruction can as easily occur when individuals stray from their chosen investment strategy, and let sentiment drive their investment decisions.
Sticking to your strategy, and leaving emotions out of the financial decision, ultimately leads to more value creation than attempting to time the market.
What about market timing?
Market timing has been extensively researched. The overwhelming conclusion is that over the medium to long term, a buy-and-hold investment strategy consistently outperforms a market timing strategy.
Why is this so? The answer is investor behaviour, and investor psychology. Let’s illustrate:
Peter manages his own investments. He has a regular job, but keeps an eye on the markets and makes his own investment decisions.
Investors are inclined to both over-excitement and overreaction. When markets are running hard, we can’t stop ourselves piling more money in to the latest ‘hot’ asset class or individual share, and so Peter keeps purchasing the latest hot stock whilst the market runs. Forget the fact that the market has already priced in all known future information on that share. History shows us that markets correct themselves, and when it does, Peter is now over-weight a share, or even a sector, that has run the hardest. When this share or sector corrects, Peter will view this correction as value destruction.
The market can overreact both ways. Peter now sees his selected share, or even sector, plummeting and decides to bail out. In his mind, he has limited his losses, but in reality all he has done is lock in his losses.
This is not just a theoretical example. This scenario has played out many times throughout market history, and not just at an individual level.
One of the most recent examples was during the ‘Tech bubble’. The NASDAQ experienced record monthly inflows in March 2000 of $53 billion. The NASDAQ has been nowhere near the highs of March 2000 since then. When the tech bubble burst these record inflows were almost matched by record outflows in July 2002 of $49 billion. Even taking the current market conditions into account, if those investors had sat tight, they would currently be in a better position than when they sold out in July 2002.
What could be a reason for this phenomenon of buying at the peak and selling at the bottom?
The human brain looks back and draws on experience to make decisions. The stock market looks forward and prices shares using all known future information.
As prices run, the brain looks back and says: “Gee, we’re missing a great opportunity here”. Forget that the market has already priced this share. Our brain tells us we have to be a part of this run. Reactive decisions like these can be catastrophic to your long-term wealth creation.
History is littered with such examples, yet we continue to believe that this time it is different.
So what is the solution to Peter’s investment strategy problem?
Value creation occurs over the long term, not the short term. Short-term gains may be made through market-timing, but the probability of never getting it wrong is highly remote. Getting it wrong, and then being reactive, can very quickly destroy any value you have created. The solution is to devise a strategy that meets your ultimate requirements, and that fits your current capabilities. Then trust that strategy, and do not waiver through the volatility of the market. Review your strategy annually, but avoid making wholesale, knee-jerk alterations. Keep the ultimate goal in mind.
I recommend you yo engage an independent, fee-based CERTIFIED FINANCIAL PLANNER® who is focused on your best interests and can provide impartial advice. If you do not know of one, visit the Financial Planning Institute’s website on www.fpi.co.za to select one.
Debbie Netto-Jonker CFP® is the founder of Netto Financial Services and was Financial Planner of the Year in 2001. Her business partner, Ian Beere CFP® was the Financial Planner of the Year in 2007.