22/10/2014

3 Ways To Avoid Going Off A Stock Market Cliff With The Buy-And-Hold Herd - Forbes

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Janet Novack Forbes Staff

I write from D.C. about tax and retirement policy and planning.

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10/21/2014 @ 11:21AM 5,768 view s

3 Ways To Avoid Going Off A

Stock Market Cliff With The
Buy-And-Hold Herd
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GUEST POST WRITTEN BY

Kenneth G. Winans

Kenneth G. Winans is a veteran investment manager based in Novato, Calif.

The stock market is teetering right now. The S&P 500 fell below its 200-day
moving average on October 13. I think more investors especially older ones
should sell equities if we are still below this mark on Halloween.
That advice is probably going to upset some respectable people. In
a Bloomberg interview last month John Bogle Vanguard Groups venerable
maestro of passive strategies once again extolled the wisdom of buy-andhold investing. Small investors who actively trade in and out of the market,
Bogle said, are going to cut their own throats.
Bogle published his famous book, Common Sense on Mutual Funds, in 1999
at the end of what had been a long and steady bull market. At that time, the
numbers did paint a nice picture of the benefits of passive investing. Bogle
pointed out, in a chapter called On Indexing, that the S&P 500 had
outpaced a stunning 96% of all actively managed equity funds.
Plenty of academic research backed that view. And Bogles refrain stick
through the rough patches and youll come out OK has become an anthem
for Baby Boomers readying for retirement. But have you noticed that the other
voices from the passive-investing choir become a good deal fainter when the
stock market symphony hits a crescendo and starts to drop as it has over
the past few weeks?
The last decade has seen some pretty perilous falls, so its no wonder that
people begin to choke up when they think were in for another round. No
matter how much investors like to sing the buy-and-hold tune, it becomes a lot
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3 Ways To Avoid Going Off A Stock Market Cliff With The Buy-And-Hold Herd - Forbes

harder as the market heads down. In fact, recent research from

Morningstar has shown that the average mutual fund generates higher returns
than the individual investors in the funds themselves earn.
One reason for the discrepancy: human psychology. Few people have the
discipline to execute a true buy-and-hold strategy. They get too excited and
buy into late-stage bull markets and get frightened when the market falls,
bailing out at what ends up to be the near bottom of a bear market.
But what if an investor were a model of self-discipline? My own research
confirms that investors who followed Bogles advice to the letter would
perform spectacularly during periods of low volatility like we witnessed in the
1980s and 1990s. But you may be surprised by what else I learned: The
pattern breaks down as volatility picks up as it has in recent years.
I ran some numbers myself back in 2011 and reran them recently. I compared
the performance since 1979 of a buy-and-hold Bogle adherent to that of an
investor who sold off Vanguards 500 index fund during significant market
corrections, then bought the fund back once the stock market regained
momentum. I found that the latter investor the one who probably slept
better at night during the big stock market corrections garnered higher
returns than the investor who stuck with Bogles strategy. Mr. Sleepwells
portfolio did lag a bit during the great bull market of 1982 through 1999, but
it more than made up the lost ground in the volatile markets that followed.
This research has bolstered my sense that, at the very least, more investors
should have a plan in place to defend against big market corrections. Your
strategy doesnt have to be the one I would choose. But its wise to have one
ideally one that you and your financial advisor set in place long before the
market tanks.
If youve never talked with your financial advisor about a rainy-day plan, here
are three worth exploring.
Method 1: Buy-and-sell. If you look up and see a bowling ball falling out of
the window youre standing under, will you brace yourself and hope for the
best? No. Youll step out of the way. This is the essence of what I call the buyand-sell strategy.
At month end, the S&P 500 closed below its 200-day moving average only 12
times in the period between 1979 and 2013. This signal, it turns out, has been
the equivalent of a bowling ball falling out of a window. Its also an easy
number to check the 200-day moving average is freely available on any
number of financial data websites. So I check the moving average at the end of

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3 Ways To Avoid Going Off A Stock Market Cliff With The Buy-And-Hold Herd - Forbes

each month, and when the index is 2% or lower than its 200-day average, I
take the hint and step out of the way by shifting my clients assets to money
market accounts.
When the S&P 500 moves 2% or more above the 200-day moving average
again, I shift back into the equity market.
The table below shows how well this strategy has worked over the past 35
years. Here I assume that I funded two portfolios with an initial investment
slug of $25,000 in 1979, then reinvested dividends at month end. One of the
portfolios passively invested in the Vanguard S&P 500 Index Fund (VFINX);
the other invested in the same fund, but used the indexs relationship to the
200-day moving average as a sell signal.

Looking at this table as a chart, the trend comes through loud and clear (note
especially the two lines starting in 1999 each time the blue line plunges, the
orange line remains flat; when the blue line advances, the orange line at least
keeps up). The final result: Our buy-and-sell investor garnered an 11.7%
average annual return over the 35-year period, beating the 10.3% return for
the Bogle investor by 1.4 percentage points.

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3 Ways To Avoid Going Off A Stock Market Cliff With The Buy-And-Hold Herd - Forbes

This test, you might object, is not realistic. Most people invest a little every
month rather than investing a single, large slug its called dollar-cost
averaging. So I ran the numbers on investing $100 per month and found that
the results looked very similar:

The graph version of this table also looks much the same as the first. The buyand-hold line is ahead of the buy-and-sell during the low-volatility secular bull
market, but the buy-and-sell pulls further and further ahead as volatility picks

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3 Ways To Avoid Going Off A Stock Market Cliff With The Buy-And-Hold Herd - Forbes

up:

This is a strategy that any do-it-yourself investor can understand. But like any
investment strategy, it has its weaknesses. If you are implementing this
strategy in a taxable account, for instance, selling stocks for a gain will trigger
a capital gains tax bill. Also, the idea of following this strategy absolutely,
getting entirely in and entirely out of the stock market, can produce its own
anxieties, leading to inaction. Its harder to pull off than it seems.
So enlist the help of an active investment manager, with a proven bear market
track record, who can help navigate these issues. Yes, youll pay a fee to the
manager for his or her help usually 1% of assets under management. But
even after paying that 1% fee per year, youd have outperformed a passive buyand-hold investor by an average of 0.6% annually since 1979.
Method 2: Asset class balancing. In our example above, weve made a
black-and-white choice either stocks or cash. But some experts prefer more
of a gray strategy one that mixes stocks and bonds together in a single
portfolio according to a predetermined proportion, then makes sure that the
proportion stays the same by periodic rebalancing.
Heres how to set it up. Determine a target allocation between stocks and
bonds. Most experts recommend a 50-50 or 75-25 split, depending on your
own risk profile (50-50 for more risk-averse investors, 75-25 for less). Once
youve decided on a proper split, allocate your portfolio according to those
values.
Now, every year, you assess the relative size of each of your allocation baskets.
If stocks have been on a tear, you may start the year with a 50 % stock
allocation, but end it with 60 % in equities. At this time, you take profits on
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3 Ways To Avoid Going Off A Stock Market Cliff With The Buy-And-Hold Herd - Forbes

part of your stock portfolio and plow those profits into the bond market so that
your actual allocation again meets your target allocation of 50-50 stocksbonds.
If the stock market falls during the next quarter, the allocation shifts again.
Lets say your portfolio falls to just 40% stocks. In this case, you would use
dividends and interest payments to buy stocks until your actual allocation
returned to your target allocation.
This strategy has the advantages of being simple to execute, dampening excess
equity market volatility and enforcing the discipline of buying low and selling
high.
There are, however, a few problems with it. You should note that
diversification is not the same as protection. Asset reallocation schemes like
this one will cushion your portfolio from equity market falls, but at the
expense of returns (because not all of your portfolio is exposed to equity
market gains). You should also note that the portion of the portfolio allocated
to equities is completely unprotected. Seeing the equity portion of your
portfolio soaked in red is not the best recipe for a good nights sleep,
regardless of whether your portfolio as a whole is cushioned thanks to bond
exposure.
Method 3: Hedge against a bear market and the IRS. The
problem with selling in a taxable account is that the investment taxes you face
from equity sales can be larger than the losses caused in a minor stock market
correction. So based on tax advice given by his accountant, an investor may
avoid selling stock investments even if he thinks his stocks are overpriced and
the bull market is over.
So consider hedging strategies. They can be a cost-effective and taxeffective substitute for investment liquidation during bear markets.
Some investors succeed using options to hedge. My weapon of choice for
hedging stock portfolios is the ProShares Short S&P 500 ETF (Sym: SH). This
is an exchange-traded fund that normally rises in value when the market
plunges. It can be purchased in any type of brokerage account. Its expense
ratio is reasonable. It performed well in the market collapse of 2008. (Note:
When the market crashed, the ETFs value went up albeit not in exact
inverse proportion to the markets fall. Be aware that the way these
instruments are constructed means that short ETFs do not perform exactly
the way most investors expect them to. Again, heres a tool that is worth
discussing with a good financial advisor.)

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3 Ways To Avoid Going Off A Stock Market Cliff With The Buy-And-Hold Herd - Forbes

Markets drop your net worth doesnt have to. Since the dot-com
bust, one thing has been very obvious to even the most casual observer:
Markets drop. By my count, they have done so every third year or so over the
last century.
Theres much to admire about Jack Bogle. But hes wrong about buy-andhold. You owe it to yourself and your portfolio not to join in his passiveinvesting choir. Today, all the major U.S. indices are below their 200-day
moving averages. Whether you sell stocks, use an asset-rebalance strategy, or
deploy some sort of hedge protection is up to you and your financial advisor.
What are you going to do?
Kenneth G. Winans is a veteran investment manager based in Novato, Calif.
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