The Buy and Hold Investors' Nightmare
By Mark Kramer
Being a Buy and Hold investor is like living through a nightmare where you find yourself the main character of the Greek "Myth of Sisyphus."
Futile and Hopeless Labor: In this myth, Sisyphus is condemned by the god Zeus to an eternity of futile and hopeless labor. He must roll a heavy stone to the top of a mountain. But then the stone rolls all the way back down … and Sisyphus has to push the stone back up again to the top.
A sentence of "futile and hopeless labor" is similar to the situation that Buy and Hold investors have faced during many periods of stock market history. Since "Bull" Markets are inevitably followed by "Bear" Markets, the investor's hard-won gains from the Bull Market up-cycle evaporate as market prices fall during the Bear Market down-cycle.
That's not to say the stock market hasn't gone up over time. Looked at over hundreds of years, the market has grown at a 7% average growth rate. You might say: What's the matter with 7%? The problem is that in order to have a statistically high probability of achieving an average growth rate that high, you should expect a potential wait of as long as 20 to 40 years!
Bear Markets Appear at Regular Intervals: Looking at the past 200 year historical record as author John Mauldin does in his book Bull's Eye Investing, there have been 7 "secular" bull market cycles and 7 secular bear cycles … the bulls averaging 14 years in length and the bears 15 years. The word secular means "era" as in a long time.
Bull and bear cycles are long enough to consume a major portion of your earning years. Look at the cycles of the past century: The Depression-era bear market cycle lasted from 1929 to 1945. Then the bull cycle after World War II lasted from 1946 to 1964. After that, a new bear market cycle lasted from 1965 until 1981. The most recent bull cycle lasted from 1982 to 2000.
• 15 to 20 years is a long time to wait for nothing better than a zero or negative return.
We are Now in a Secular Bear Market Cycle: Bull market cycles are preceded by very low stock market valuations (low P/E ratios); and bear cycles begin after periods of very high valuation.
• The "bubble" peak year of 2000 saw record-high P/E ratios reflecting manic levels of bullish hysteria at the end of an 18-year secular bull cycle.
It is quite reasonable to view the 3-year bear market that began in 2000 as just the opening act in a new secular bear cycle that could easily last until about 2015 if you assume an historical average.
• But secular bear cycles will include bullish interludes … just as bullish eras have included regular bearish phases.
Secular Bear Cycles have Plenty of Ups and Downs: In fact, during the average bear market cycle, roughly 42% of the years have been up years according to John Mauldin in Bull's Eye Investing. The intermediate up-cycles last about 2 years on average. On the flip side, secular bull cycles show a similar but opposite tendency. Since 1900, about 17% of the years during secular bulls have been down years.
The current bullish phase in the stock market is most likely just one of those bullish intermediate up-cycles that usually appear in the middle of secular bear cycles where the predominant, long term trend is down. So the current bull market period is likely to roll over into a continuation of the secular bear down-cycle that began in 2000.
A Nightmare for Buy and Hold Investors: So far in this decade, Buy and Hold investors have probably felt like the mythical Sisyphus. After making fantastic gains during the Roaring 90's, many investors lost between 30% and 70% on their stock market portfolios during the bear market of 2000 to 2003. Then a bullish interlude began in 2003. If an investor was fully invested at the beginning of this phase, they have probably recouped about 70% of what they had lost.
• Almost 7 years into the new secular bear market cycle and the average Buy and Hold investor is still down about 15%, in spite of the recent bull market interlude.
The Nightmare has only Just Begun: The current bullish interlude is likely running out of steam. At nearly 4 years in duration, this bull is getting "long in the tooth" by historical standards. Looking forward from where we stand today, the average investor can expect a pattern of more frequent and punishing Bear Market periods in between Bull Market interludes.
Since the total return on stocks has typically been negative or near zero over a complete secular bear cycle, the Buy and Hold investor … who has already waited 6+ years … could easily have to wait another 6 to 7 years and still receive no positive net return.
Most investors' natural reaction would be to flee the exits and put all their money in bonds, CD's and bank accounts. But how is a growth-oriented investor to know when it is safe to get back into the market … when to take advantage of the drop in stock prices?
• Now there is an effective way to make the market's up and down cycles your friend, how to know when it is safe to get back in to the market as well as when you should get out.
Market Timing to the Rescue
Market timing has historically been a rather dubious art, particularly as practiced by a colorful variety of "market gurus" who tried to build reputations by picking market tops and bottoms.
• But computers and quantitative modeling techniques are changing the reputation of market timing. Today, increasing numbers of sophisticated investors are coming to appreciate the potential effectiveness and power of disciplined market timing techniques.
The primary benefit of a longer-term market timing model is to capture the big market trends … up and down. If you can effectively capture the up cycles and avoid the down cycles, your portfolio will be miles ahead of the Buy and Hold investor.
But You Have Heard that Market Timing Doesn't Work: Yes, that is what you've heard from the entrenched interests within the financial business … they can make more money off you as a Buy and Hold investor. But there are a growing number of financial advisors, investment newsletters and portfolio managers that are embracing the new technology simply because it works.
• And now there are several mutual fund families that cater to market timers. The two biggest are Rydex Investments and ProFunds, Inc.
One alternative to market timing is to hire an investment advisor who is a very good stock picker. The challenge will be to successfully pick stocks that continue to perform well during bear markets when an extremely high percentage of all stocks go down. That is a huge challenge and good stock pickers are very hard to find.
Another alternative is to structure your portfolio with a high percentage of bonds and cash, using a traditional asset allocation approach. This method will reduce the potential degree of loss during Bear Markets, but whatever portion you allocate to stocks could still lose 40% or more and may take you many years of patience just to reach breakeven.
The Best Alternative: Tactical Asset Allocation
You can take long term market timing one step further and build it into a disciplined asset allocation process that dynamically follows changing market trends in multiple asset classes (such as bonds, stocks and real estate).
The point is to use timing techniques for each asset class to capture the up-cycles and avoid most of the periods of under-performance and losses.
• This is the most efficient approach to asset allocation … because it mostly eliminates the long periods of under-performance that would be inevitable using a traditional asset allocation of fixed investments.
The average investor can now more easily access this sophisticated approach through multiple avenues … individual investment advisors that use the approach and investment newsletters that offer model portfolios based upon market timing techniques. In addition, several mutual fund companies, including Rydex Investments and the Hussman Funds, have introduced mutual funds based upon market timing technology.
And there is the "do it yourself" approach. An increasing number of trading software packages offer the analytic capabilities for individual investors to experiment with their own quantitative timing techniques. Many day traders have already figured this out.
But as a long term investor, your objective should be to invest heavily in the market during a period like the 1990's and then to be out of the market during a bear market like 2000 to 2003 when a huge destruction in value occurred.
• Capture the huge trends and you will mostly compound profits on top of profits and the power of long term compounding will take over to accelerate the growth of your portfolio.
We aren't in the 1990's Bull Market anymore. You will need a more sophisticated investment strategy to be successful in the years ahead ... one that can make money in spite of the inevitable bear markets. Now you can avoid the nightmare and tragedy of the Greek Sisyphus. To stay on top of the volatility observed in market cycles Mark recommends that you subscribe to a investment newsletter that provides you investing tips and advice about market timing.
About the Author
Mark intends to share his investment knowledge and model portfolios for index funds and exchange traded funds to help investors make smarter investment choices in the stock market and mutual funds. If you would like to learn more about investing in the stock market and mutual funds visit http://www.confidentstrategies.com to sign up for our free investment newsletter.
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