The New Buy-and-Hold Investing Paradigm is the investing paradigm of the future. This article describes eighteen tenets of the new investing paradigm that were generated by my reflection on the discussions held at Financial Freedom Community discussion boards during the first 43 months of The Great Safe Withdrawal Rate Debate.
The following investing experts and community members (names in quotes are screen-names used in discussion-board posts) helped in some significant way in the development of the insights sketched out below: (1) John Walter Russell; (2) William Bernstein; (3) Rob Arnott; (4) Robert Shiller; (5) Andrew Smithers; (6) “raddr;” (7) “BenSolar;” (8) Peter Ponzo; (9) Peter Bernstein; and (10) Scott Burns. The words below are my own tentative thoughts on this topic. None of the investing experts or community members listed here necessarily agree with the ideas put forward below.
The first tenet of The New Buy-and-Hold is that holding stocks for the long term is a good idea.
The idea that it is a good strategy to hold stocks for the long term has become so popular that to many it now seems a self-evident truth. But it is not obviously the case that it is a good idea to buy stocks only when you feel comfortable in holding them for a long time. Plausible cases can be made for alternate strategies.
For example, it could be argued that momentum investing is a good idea. A case can be made that, when stocks have been going up for some time, they are likely to continue going up; and that, when stocks have been going down for some time, they are likely to continue going down. Obviously, there are times when the momentum in either direction breaks. These times would be viewed as times to change strategies by those following a momentum investing approach.
It also could be argued that it is best to follow a fluid approach to buying stocks, to buy when it seems likely that prices will soon be advancing and to sell when it seems likely that prices will soon be declining.
Buy-and-hold has become popular not because there are no reasonable alternatives to it. It has become popular because the historical stock-return data provides meaningful objective support for the claims of proponents of this investing strategy. Buy-and-hold stock investing has been demonstrated to be a good idea for most, at least in the eyes of a good number of the smartest and most reasonable-sounding investment analysts.
Advocates of The New Buy-and-Hold endorse buy-and-hold investing not unthinkingly or because it is popular, but because we believe that the historical stock-return data contains a wealth of evidence showing that buy-and-hold investing really does work.
The New Buy-and-Hold Investing Paradigm is properly seen as a paradigm which builds on and improves on the Stocks-for-the-Long-Run Investing Paradigm rather than as one that rejects the old paradigm. The new paradigm rejects certain tenets of the old paradigm. It endorses others. It sees great value in the strategy of aiming to diminish the risks of owning stocks by holding them for the long term.
The second tenet of The New Buy-and-Hold is that stock prices are to a large extent predictable in the long term.
Stocks are widely appreciated as a high-growth asset class. Yet middle-class investors were long reluctant to invest too heavily in stocks because their prices are so volatile. The Stocks-for-the-Long-Run Investing Paradigm eased middle-class concerns regarding the risks of owning stocks by arguing that downturns in stock prices are almost always temporary, that in the long run stocks always recover and provide a solid return.
Advocates of The New Buy-and-Hold to some extent agree and to some extent disagree.
The historical stock-return data indicates that it is difficult indeed to predict how stocks will behave over the course of the next year, the next three years, or the next five years. In the long-term, however, stock prices appear to be remarkably predictable. So it really does seem that investors can to a large extent overcome the apparent risk factor in buying stocks by planning to hold them for the long term.
The core flaw of the old paradigm is its contention that stocks are at all valuation levels an equally attractive investment class. This contention contradicts the belief that stock prices are predictable. If stock prices are predictable, and if stock returns are at some times not as good as at others (this is obviously so), then there must be some times at which informed predictions of long-term stock returns make stocks appear a less attractive asset class than at other times.
Say that you were to purchase $100,000 worth of an S&P index fund today and that, one month from today, the price of the S&P index were to fall by 50 percent. If stocks were at all valuation levels an equally attractive asset class, the loss would be a devastating blow. There would be no reason to believe that the S&P index were now in a position to provide better long-term returns than it was in a position to provide before prices dropped.
The old paradigm argues that long-term stock prices are predictable but rejects the logical implication that stocks are at some times a more attractive buy than at other times. The New Buy-and-Hold argues that long-term stock prices are predictable and that stocks are therefore a more appealing asset class at times of low valuation than they are at times of high valuation.
The third tenet of The New Buy-and-Hold is that the historical stock-return data provides valuable guidance for predicting long-term stock returns.
The historical stock-return data indicates that stock returns become more predictable as more time passes. It appears to be very hard or even impossible to predict what will happen within five years. It appears to be not too hard at all to predict what will happen within 60 years (presuming that the U.S. economy remains roughly as productive as it has been in the past, the super-long-term annualized real stock return is likely to be something in the neighborhood of 6.8 percent). And it appears that for time-periods of about 30 years stock prices are in part predictable and in part not.
This last reality has caused a great deal of confusion for many investors and even for many investing experts.
The reason why stock returns are highly predictable in the super-long-term is that stocks are ownership shares in businesses. So long as you own a broad index fund, and so long as the U.S. economy performs as it has in the past, the super-long-term value of an ownership share in all U.S. businesses can be estimated with a good measure of accuracy.
The reality is entirely different in the short-term. In the short-term, there is no necessary connection between the value of the underlying businesses and the price assigned to the stock shares. In the short-term, stocks are a gamble rather than an investment.
In the moderately long-term (time-periods of 30 years or so), stocks are in part an investment and in part a gamble. That’s why stock prices are in part predictable and in part unpredictable over time-periods of about 30 years.
The trick to making stock prices predictable over a 30-year time-period is to do away with the gambling element of the calculation by focusing on a particular point on the spectrum of returns-sequence possibilities. Hold the variable element (the element that reflects changing investor psychology rather than the earnings of the underlying businesses) of the long-term stock return constant, and it becomes possible for you to make reasonable predictions.
This is what is done in safe withdrawal rate analysis. The safe withdrawal rate is defined in the literature as the withdrawal rate that works when a worst-case returns sequences turns up. John Walter Russell’s research (please see his web site at www.Early-Retirement-Planning-Insights.com) reveals a strong correlation between valuation levels that apply at the start of a 30-year returns sequence and the historical surviving withdrawal rate (the withdrawal rate that just barely works in a worst-case returns sequence scenario) that becomes known at the end of the 30-year time-period.
Knowing this, it becomes possible not to predict 30-year returns with precision, but to predict a range of returns likely to apply at the end of 30 years and to assign rough probabilities to outcomes at various points along the spectrum of possibilities. The stock price for a broad index that will apply at the end of 30 years is in large part (but not entirely) knowable in advance by making reference to the historical stock-return data.
The fourth tenet of The New Buy and Hold is that judgment must be applied in making use of findings generated from analyses of the historical stock-return data.
There are a number of caveats that apply in using the historical data to predict long-term stock returns. Stock prices are predictable only to the extent that the underlying businesses perform in the future roughly as they have in the past. This of course may end up not being the case.
Even in the event that the U.S. economy remains roughly as productive as it has been in the past, weaknesses of the data set used to make predictions could cause misleading findings. It would be better if we had a larger data set.
It would also be better if there were a large number of researchers who had experience developing methodologies to predict long-term stock returns. Our community’s safe withdrawal rate findings are new findings, and we need to see these findings scrutinized by a good many skilled researchers before we can possess strong confidence in their accuracy.
The fifth tenet of The New Buy-and-Hold is that buy-and-hold investing strategies are not self-executing.
Even if all of the concerns noted above could be adequately addressed, an important caveat would continue to apply for anyone seeking to use the historical stock-return data to decide on a stock allocation strategy. The ability of an investor to succeed with a long-term buy-and-hold investing strategy depends on his ability to stick to a strategy for a time-period of three decades or so.
The conventional wisdom of today (often unspoken, but usually implicit in assertions supportive of the Stocks-for-the-Long-Run Investing Paradigm) is that the juicy returns available to those who follow buy-and-hold strategies are available automatically. The idea seems to be that it is bysaying that you are investing for the long-term that you reap the appealing long-term returns. Nothing could be farther from the truth, according to the emerging paradigm.
Advocates of the old paradigm mislead investors in serious ways by suggesting that buy-and-hold investing is a self-executing strategy. The reality is that many investors who identify themselves as buy-and-hold investors have a great aversion to examining what the historical stock-return data says about how best to invest for the long-term. These investors obviously possess an even greater aversion to the idea of changing their investing strategies to bring them into accord with the messages that the historical stock-return data is really trying to communicate to us.
It is self-identified buy-and-hold investors who have argued most strongly against exploring the flaws of conventional-methodology safe withdrawal rate studies, and against correcting those studies when grave analytical flaws have been discovered in them. It is self-identified buy-and-hold investors who have dismissed the idea of looking to the historical stock-return data in analytically valid ways for insights as to how stocks may perform in the future as “fortune telling” and “crystal-ball reading.” It is self-identified buy-and-hold investors who have mocked the idea of using the historical data as a guide to how to invest on the grounds that following the lessons taught by the historical data would have caused investors to miss out on some of the temporary gains enjoyed by investors who maintained high stock allocations during the late 1990s, when valuations went to levels never before experienced in the history of the U.S. market.
There is little guidance available today that helps investors put together realistic buy-and-hold strategies. Advocates of The New Buy-and-Hold Investing Paradigm decry this weakness of the literature advancing the Stocks-for-the-Long-Term Paradigm and aim to do what they can to fill the void.
The sixth tenet of The New Buy-and-Hold is that it is not inconsistent to believe both in holding stocks for the long term and in engaging in long-term timing of stock purchases.
I took my money out of stocks in 1996. Stocks were at high valuations at the time and I was planning to leave my corporate job within a few years and become dependent on the income streams generated by my investments to cover a significant portion of my costs of living. Because stock prices are so unpredictable in the short-term, and because stocks did not appear likely to provide strong long-term returns from the valuation levels that then prevailed, it did not seem to me to make sense to allocate large portions of my portfolio to stocks until valuation levels went lower.
I plan to purchase stocks when valuations come down to levels at which I can realistically count on taking an annual withdrawal from my stock investments large enough to finance my Passion Saving plan. I have not had to make a change in my stock allocation over the course of the past nine years. Valuations have gone up and down, but none of the changes have been so dramatic as to require changes in my stock allocation.
When I do purchase stocks, I will purchase them for the long term. Say that I purchase stocks at Valuation Level X and that stocks then jump to Valuation Level Y. Does the fact that I follow a long-term timing strategy require that I sell those stocks because valuations have risen? It does not. So long as the stocks were purchased at a price that promised an acceptable long-term return, I could continue holding them while valuations temporarily rose to levels at which I would not have elected to have made the purchases.
Long-term timing is very different from short-term timing. Long-term timing does not require frequent changes in one’s stock allocation. Long-term timing is not inconsistent with following a buy-and-hold strategy. To the contrary, adjusting stock allocations in response to changes in valuation levels helps investors pursuing buy-and-hold strategies maintain them for the long term.
The seventh tenet of The New Buy-and-Hold is that there are potentially large gains to be earned from use of a long-term timing strategy.
The Stocks-for-the-Long-Term Investing Paradigm remains the dominant investing paradigm today. Recommendations of long-term timing strategies are controversial recommendations. Yet both common sense and the historical stock-return data support long-term timing.
Given the strength of the case for long-term timing and the intensity of the opposition to open acknowledgment of the strength of the case, some investing analysts have elected to take a middle-ground position in which they acknowledge that it makes sense to engage in timing but suggest that the benefits to be had by doing so are likely to be modest.
The historical data does not support this split-the-difference viewpoint. Middle-class investors seeking financial freedom early in life are not in need of half-truths. They are in need of full truths. Our goal in exploring the topics raised in this article is to gain a firmer grasp of the realities of what the historical stock-return data reveals about what strategies offer the best odds of long-term investing success.
The historical data we have examined in recent years strongly argues that the benefits of long-term timing can be significant indeed.
To get a sense of how significant the benefits can be, consider William Bernstein’s finding in his book The Four Pillars of Investing that the safe withdrawal rate for a high-stock-allocation portfolio at the top of the recent price bubble was 2 percent. That is half the safe withdrawal rate that numerous studies show applies for high-stock-allocation portfolios for retirements beginning at times of moderate valuations. Presuming that safe withdrawal rates can also move to two points or more above the rate that applies at times of moderate valuations, the difference in safe withdrawal rates from high valuations (2 percent) to low valuations (6 percent) is at least 4 percent. That’s a big difference in value propositions.
Our community’s findings from The Great Safe Withdrawal Rate Debate suggest that engaging in long-term timing can help most middle-class workers win their financial freedom a good number of years sooner than would otherwise be possible. More research is of course needed to confirm and expand on our findings. But the evidence now available to us offers no support for the half-truth that effective long-term timing strategies promise only modest benefits.
The eighth tenet of The New Buy-and-Hold is that classical investing wisdom remains relevant today.
Benjamin Graham says in his book Security Analysis (which he co-authored with David Dodd) that: “the general plan of ‘buying cheap and selling dear’ may prove quite workable.” Graham did not have access to the computer-aided analytical tools available to today’s investor. He relied on common sense and a wealth of personal study and experience to develop insights putting the lie to the absurd but now-widely-accepted Stocks-for-the-Long-Run claim that long-term timing is difficult or even impossible for the average middle-class investor to pull off.
Common sense never goes out of style. When newly developed statistical tools indicate that real-world-tested common sense is “wrong,” it is time to question the methodologies employed in the use of the new tools, not to dismiss common sense and hard-won experience. In time, statistical tools that generate results that defy common sense and hard-won experience (such as the conventional-methodology safe withdrawal rate studies) fall to tools that make use of historical data to enhance what we know from the use of common sense and hard-won experience. It is always better to pay a low price for an asset than to pay a high price for it. That is why advocates of conventional safe withdrawal rate analyses have never been able to explain their core assumption that the stock asset class is an exception to the otherwise universal rule.
In short, Benjamin Graham has been proven right in recent years. Those who jumped too soon to conclusions that the classical investing wisdom had been overturned by statistical tools developed in recent decades have been proven wrong. Employed in analytically valid ways, the new statistical tools support Graham and others who long offered investing insights rooted in common sense and real-world investing experience.
There was a time (prior to the mid-1980s, when the Stocks-for-the-Long-Run Investing Paradigm became the dominant influence on our understanding of how stocks work) when there was widespread agreement among investors that stocks represent a better buy when they are cheap than they do when they are expensive. Consider the old maxim to “buy low, sell high.” Maxims usually are rooted in at least partial truths. The emotional reaction to advocacy of long-term market timing often evidencing itself in today’s discussions of how to invest successfully for the long term is itself a compelling bit of evidence that the new thinking on how to invest is the product of the longest and strongest bull market in U.S. history more than it is the product of well-constructed research unveiling the lessons of the historical stock-return data.
Bull markets come and go. So do bear markets. It is the fundamental rules that apply as time goes by. And the importance of taking valuations into account when purchasing an asset is one of the fundamental rules. During extreme bull markets (and during extreme bear markets too), the tried and true insights of analysts who have shown an ability to overcome the emotions of those losing their heads in deference to the conventional investing wisdom of the day are a valuable source of reasonable and practical guidance on how to invest successfully for the long term.
The ninth tenet of The New Buy-and-Hold is that holding stocks for the long-term is difficult.
The short-term successes of the Stocks-for-the-Long-Term Investing Paradigm have persuaded many analysts to determine their asset allocation recommendations by looking at what would have happened in the long term to investors of the past who held large stock allocations at market tops and then sold zero shares when stock prices tumbled. Advocates of The New Buy-and-Hold view the assumption that those with large stock allocations will not reduce their allocations in bear markets as unrealistic in the extreme.
Investing is an emotional endeavor. Highly volatile asset classes cause investors to feel negative emotions more intensely than do less volatile asset classes. Investors who go with high stock allocations at times of high valuations dramatically increase the emotional stress they are likely to experience over the long term. Emotional reactions have long been the primary cause for failure of investing strategies designed to pay off in the long term. Advocates of the Stocks-for-the-Long-Run Investing Paradigm have in recent years not been able to put forward any reasoned argument for why they believe that “it is different this time.”
William Bernstein notes in his book The Four Pillars of Investing that, if valuations were to fall to lows they have reached twice before in U.S. history, the Dow Jones Industrial Average would fall from its high of close to 12,000 to 1,400. “It is unlikely (but not impossible) that the Dow will drop as far as 1,400 at any time in the future, but recall that at least twice in this century U.S. investors indeed did demand a 15 percent discount rate,” says Bernstein. Bernstein believes it is exceedingly unlikely that the DOW could fall to a number anywhere in that neighborhood. But he finds the results of the calculation shocking all the same. So do I.
Many middle-class investors have been given assurances that stocks always do fine in the long run without being properly cautioned of just how volatile this asset class often turns out to be for those who invest heavily in it at times of high valuations. The key to obtaining the rewards that really do come to investors who stick with stocks for the long term is going with stock allocations that can be sustained through dramatic price drops. Buy-and-hold investing is smart investing, but the historical stock-return data shows that it isn’t easy being a buy-and-hold investor.
The time to position oneself for big price drops is before prices fall. Those who go with moderate stock allocations at times of high valuations are more likely to succeed as long-term buy-and-hold investors than are those who ignore the warnings in the historical stock-return data of the dangers of betting too big on stocks at the tops of white-hot bull markets.
The tenth tenet of The New Buy-and-Hold is that attempting a buy-and-hold strategy that fails can generate the worst of all possible investing outcomes.
Stocks held for the long term generally produce good returns. Non-stock investment classes generally produce returns that are less exciting than those generated by stocks held for the long term, but with less volatility and thus with less risk. Stocks sold in the early stages of a downturn can produce poor but somewhat tolerable results. The worst of all possible investing outcomes goes to investors who stick with stocks well into a downturn in prices but are ultimately pressed to sell a large portion of their stocks because they over-invested in a volatile asset class at a time when they did not appreciate how far stock prices could fall and how long they could remain low.
Buy-and-hold is a good strategy only if it is applied realistically. To apply a buy-and-hold strategy realistically, an investor must look to the worst-case scenario that might turn up for him at the time he is deciding how much of his portfolio to allocate to stocks. The historical stock-return data shows that worst-case scenarios can be difficult indeed to endure for those with high stock allocations. Those with moderate stock allocations enjoy much better prospects of sticking with their stock allocations through price downturns.
Jack has an 80 percent stock allocation. Jill has a 40 percent stock allocation. Stocks fall 50 percent and remain at the lower price level for some time. Jill, who has suffered a loss in portfolio value of only 20 percent, is more likely to obtain the benefits that go to long-term buy-and-hold investors than Jack, who has suffered a loss of 40 percent of portfolio value.
The eleventh tenet of the New Buy-and-Hold is that there are many factors that affect whether a particular investor will be able to maintain his or her stock allocation through big price drops.
Most analysts acknowledge that retirees should generally go with smaller stock allocations than non-retirees. But it is not just retirement that makes an investor vulnerable to emotional pressures to sell stocks during deep and lengthy price drops.
An investor who is not yet retired but is within 10 years or even 15 years of retirement may feel intense emotional pressure on seeing his portfolio value drop by 30 percent or more.
Even investors with more than 15 years to go until retirement may feel intense emotional pressure at finding that they are losing ground in pursuit of their financial freedom goals if they were already feeling pressure prior to the price drop because they did not save effectively in their 20s and 30s. Many middle-class workers are in these sorts of circumstances today.
Many investors who got a late start saving for retirement have been advised to up their stock allocations to make up for lost time. This is dangerous advice. For an investor who got a late start saving for retirement to try to make up for lost time by going with a higher stock allocation than he would otherwise deem appropriate is like a gambler who is down on his luck doubling up his bets to “get even” more quickly. This is a strategy as likely to bring on a greater sense of panic as anything else.
It is investors who are feeling comfortable with the progress they have made pursuing their financial freedom goals who should feel positioned to go with higher stock allocations, not those who are in the sorts of life circumstances in which sharp price drops might cause an especially keen sense of loss and regret.
The twelfth tenet of The New Buy-and-Hold is that the power of an effectively carried out buy-and-hold strategy is great enough that most of those employing effective strategies should maintain modest stock allocations even at times of high valuation.
The historical stock-return data indicates that stocks provide surprisingly good returns to true buy-and-hold investors even for purchases made at high valuation levels. Stocks offer a better value proposition at times of moderate and low valuations, to be sure. But so long as you are careful to position yourself to maintain your stock allocation or increase it at times of low valuations, stocks probably should comprise a modest portion of your portfolio even at times of high valuations.
Even for those who do not feel comfortable engaging in long-term timing strategies, avoiding excessively high stock allocations at times of high valuations makes sense. An alternate strategy is to maintain a modest allocation to stocks at all times.
The thirteenth tenet of The New Buy-and-Hold is that it is not possible for any middle-class investor to take a purely long-term perspective on his or her investing success.
Investing for the long-term is a good idea. Positioning yourself with your stock allocation so that you do not feel pressure to sell shares when prices are down is a good idea. But there is no such thing as a middle-class investor who is so focused on the long-term that he does not feel at least some distress at seeing price drops for the portion of his portfolio invested in stocks. Many of us aim to focus on the long-term. None of us ever completely achieves this aim.
Say that you are 30 years old, don’t need to worry about retirement for a long time, and have been fortunate enough to sock a good bit away in your short investing life, enough that even large price drops will not cause you to feel severe financial stress. Price drops are still not going to make you happy. You still would prefer to have $200,000 in your portfolio rather than $150,000.
Short-term price drops are not going to make you happy no matter what your circumstances. The short-term always plays a role in influencing your investing perspectives.
There are temptations to sell stocks during price drops even for those who carefully position themselves to avoid such temptations. This is why stocks are properly classed as a risky asset class. This is why stocks provide larger long-term returns than less risky asset classes. It is the difficulty of maintaining a buy-and-hold strategy that makes the attractive long-term returns often promised to stock investors possible.
Another way of saying it is that many stock investors do not end up enjoying the attractive long-term returns that entice them into buying this asset class. Stocks are a tough horse to ride. Many get thrown off. It is because attractive rewards are paid only to some that the numbers are so appealing.
The number you often see quoted as the long-term return paid to stock investors (6.8 percent real) was not calculated by making reference to the experiences of real-world investors. That’s the number that applies in a highly imaginary world in which all investors who invest in stocks are able to maintain their starting-point allocations for the long term. If that presumption were a valid one, the risk premium for stocks (and thus the long-term return) would be a good bit lower.
The trick to successful stock investing is obtaining in the real world the sorts of returns quoted by those making use of imaginary-world assumptions. To actually obtain those returns, you need to plan more effectively than unsuccessful investors. It may be possible for you to realize for yourself the juicy long-term returns you have heard promised to all stock investors. But it is certainly not as easy to pull off as the advice of many Stocks-for-the-Long-Run Investing Paradigm analysts suggests.
The fourteenth tenet of The New Buy-and-Hold is that successful stock investing requires an ability to in many circumstances ignore ways of processing information that have been proven helpful in many other endeavors.
No human being has the time to process all information bits with a bearing on the decisions that he needs to make as he proceeds through life. We all rely on quick-cut information processing tricks in solving the puzzles of daily living. The help that these time-saving tricks provide makes us increasingly inclined to rely on them as we gain experience with them.
Say that you are trying to decide whether a new restaurant is worth checking out. There is all sorts of research that you could do. Probably the easiest way to get a good sense of things quickly, however, is to check whether the restaurant is crowded or not. If it is crowded, that’s a good sign. If no one goes there, that is a bad sign.
With stocks, it’s just the opposite. With stocks, buying when the market is crowded with buyers means tapping into a relatively poor value proposition. With stocks, buying when no one else is much interested means obtaining a very attractive value proposition indeed.
Stock buying is in important respects a life activity that takes place in Bizarro World, the world where Superman is a 90-pound weakling regularly getting sand kicked in his face by the local bully and hearing his girl offering the consoling words “don’t let it bother you, little man.”
William Bernstein, author of the book The Four Pillars of Investing, says that: “The best investors are somewhat psychopathic and antisocial.” I think that is running a bit too far with a sound insight. It does help, however, to develop a habit of looking at things from a perspective contrary to the one that comes naturally to mind.
The fifteenth tenet of The New Buy-and-Hold is that safe withdrawal rate analysis offers a powerful aid to overcoming the emotions that have caused most middle-class investors of the past to sell stocks at the worst possible times for doing so.
Safe withdrawal rate analysis tells you what percentage of his or her portfolio a retiree can withdraw to cover living expenses each year, presuming that stocks perform in the future roughly as they have in the past. At times of moderate valuations, the safe withdrawal rate is about 4 percent. At times of high valuations, it can drop to 2 percent or lower. At times of low valuations, it can rise to 6 percent or higher. Changes in the safe withdrawal rate reveal changes in the value proposition of a stock purchase. They show that stocks are an amazing buy at times of low valuations, a strong buy at times of moderate valuations, and a not-entirely-bad-but-not-entirely-good buy at times of high valuations.
Keeping track of changes in the safe withdrawal rate (or the results of other data-based analyses that perform similar functions) is a great way to counter the natural emotional pull you feel to buy stocks when you should be selling them and to sell stocks when you should be buying them.
Say that you lower your stock allocation to 30 percent because of valuation concerns and that not long after you do so we do indeed experience a 50 percent drop in stock prices. That’s bad news for your investing dreams. You have lost 15 percent of your portfolio value, and that means that you now enjoy a significantly lower level of financial freedom than you enjoyed in the days prior to the price drop.
For you, it’s good news too, however. A 50 percent price drop translates into a big increase in the safe withdrawal rate for stocks. A plainer way of saying it is that a 50 percent price drop translates into a big increase in the value proposition of buying stocks.
Circumstances have changed so that now you can afford to go with a stock allocation of a good bit more than 30 percent while still enjoying the level of long-term safety that you enjoyed with the 30 percent stock allocation at a time of considerably higher prices for stocks. One door has been closed for you with the lowering of your portfolio value by 15 percent. Another door has been opened by Mr. Market’s decision to offer a considerably larger income stream per dollar allocated to this investment class.
Investors following realistic buy-and-hold strategies see something good and something bad in all price moves. Price moves in an upward direction enhance their portfolio value but lower the safe withdrawal rate for stocks (and the value proposition obtained by a purchase of stocks). Price moves in a downward direction enhance the safe withdrawal rate for stocks (and the value proposition obtained by a purchase of stocks) but lower portfolio value.
Those following The New Buy-and-Hold Investing Paradigm can’t lose from changes in stock prices and can’t win from changes in stock prices!
That’s as it should be. Long-term investing shouldn’t be about taking bets and hoping that you enjoy good luck and avoid bad luck. One realistic goal would be to obtain in an acceptable time-period the annualized long-term return for stocks (about 6.8 percent real). That can only be done by increasing your stock allocation at times of low valuation and lowering your stock allocation at times of high valuation. Following a strategy of maintaining a constant stock allocation from the day you first purchase stocks makes it likely that it will take you longer to achieve a 6.8 percent annualized real return because you maximize your long-term return by adjusting your stock allocation percentage to take advantage of changes in the value proposition offered by stocks.
The sixteenth tenet of The New Buy-and-Hold is that a host of insights for pursuing effective buy-and-hold strategies can be developed through analysis of the historical stock-return data.
John Walter Russell began his research into what those seeking financial freedom early in life can learn about how to invest from the historical stock-return data in May 2002, when I put a post to a Motley Fool discussion board questioning the methodology used in conventional (now discredited) safe withdrawal rate studies. He has been pursuing the data where it led him for the benefit of our community ever since. Highlights of his research have been posted to the www.Early-Retirement-Planning-Insights.com site.
Insights developed by Russell include the following:
1) The most dangerous years of a retirement are the first eleven years. As a general rule, if you can avoid big portfolio hits in the first eleven years, your retirement success becomes considerably more likely;
2) Rebalancing a portfolio has value when done at times of high valuations for stocks because it causes a lowering of stock allocations in circumstances in which it is a good idea to lower stock allocations. The benefits of rebalancing in other circumstances have often been overstated; and
3) The often-repeated claim among retirement planners that withdrawing 5 percent of a portfolio’s current balance is roughly equivalent to withdrawing an inflation-adjusted 4 percent of its initial balance does not stand up to scrutiny.
Russell and a good number of others have mined scores of insights helpful to investors seeking to engage in realistic buy-and-hold investing. Many more research initiatives will likely suggest themselves as middle-class investors pursuing financial freedom dreams become ever more aware of the need to replace failed Stocks-for-the-Long-Run Investing Paradigm strategies with strategies more in tune with what the historical stock-return data indicates is likely to produce long-term success.
Our article on Valuation-Informed Indexing offers some preliminary thoughts on how to put the insights of The New Buy-and-Hold to practical use.
During the glory days of The Stocks-for-the-Long-Run Investing Paradigm, it became a popular sort of parlor game to attempt to identify by looking at the historical stock-return data an optimal stock allocation that applies for all investors. Investing strategies must always be customized to be effective. So the idea that there could be any one stock allocation that is optimal for all is dangerous nonsense.
The New Buy-and-Hold Investing Paradigm does not reject one particular finding that a particular stock allocation is optimal. It rejects altogether the idea that an optimal allocation that applies across the board can be determined by making reference to the historical data.
The eighteenth tenet of The New Buy-and-Hold is that the buy-and-hold concept is a relatively new one and not yet well understood.
We have lots of work ahead of us. Luckily for us, it’s fascinating stuff to think about and talk over at our boards. Let’s follow John Walter Russell’s regular injunction and begin having ourselves some serious fun, fellow Passion Savers!