Diversification, Long-Term Horizon, Buy and Hold: Still Relevant?

When it comes to investing, the general public has been steadily moving away from the old adages that called for set allocation between the (perceived) safe bonds/cash and the (supposedly) more risky stocks. Nowadays, we have all become heavy investors in the stock market, whether it’s outright ownership or group purchasing through our work-sponsored pension plans.

Last week, I talked about the importance of market timing, particularly when it comes to market entrance or exit points. When we choose to enter or exit have the largest impact on overall portfolio return, much more than the year-on-year growth, diversification, asset allocation and all the detailed balancing and fine-tuning. Today, I want to continue the thought on market timing, and address the issue of long-term riskiness of stock market investment.

We have been conditioned to believe that in the long run, the market goes up consistently. Certainly, there are occasional dips, but many of us have probably heard of the success stories achieved by market-illiterate pensioners that retired comfortably by holding steadfastly to their basket of stocks for decades. Does this much-embraced truism still ring true in face of such market carnage? In addition to my guest post at GenX, here are more thoughts on what we can learn from the market bust.

Imperfections of diversification

One of the major cornerstones of modern portfolio theories is the benefit of diversification. Most of the time it worked. This time it didn’t, at least when applied to the stock market. There are many reasons why it didn’t. But unless you’re an octogenarian and a historian with a succinct understanding of the intertwined global financial and consumer market, and foresaw the implication of mass de-leveraging and forced liquidation, and allocated a substantial portion of your portfolio in non-stock investments, you probably didn’t benefit from diversification this time around.

In fact, long-term, buy-and-hold, value investor guru Warren Buffet, had gradually shaved his 73.5% stock holding in his portfolio in 1995, to just 25% in June, 2008. Because even he didn’t believe that diversification offered him any protection when the overall market was massively over-valued.

That’s not to say that diversification doesn’t work. It does, but only to a certain degree. Slicing and dicing stocks into ever so minute classes, series and geographic reach has not offered most investors the protection they sought.

Long-term riskiness of stock returns

A new study came out just over a month ago that attempted to poke holes in current statistical methods applied in measuring volatility. Traditionally, statistics have shown that market returns over long periods have been consistent. Thus, good returns have been followed by subpar ones, and the reversion to the mean usually paints a picture that points upward in the long run.

Applying the new and unorthodox methodology, the statisticians have found that forces other than mean reversion affect long-term returns. In one instance, the researchers claim that uncertainty about market fluctuations increases with the holding period, because uncertainty is more difficult to quantify in the long-run.

As summarized by Mark Hubert, one of the best examples of uncertainty in the long run is the case of global warming. Its impact over the next year is most likely next to nothing, but should the horizon be expanded to the next few decades, possible effects may range from “negligible to catastrophic.” Applying the Bayesian statistical model, where new information is continually incorporated into the formula to update probabilities, the researchers estimated that stock market returns over a 30-year horizon is almost one and a half times more volatile than returns over a 1-year horizon.

Buy and hold

It’s time to look at whether the buy-and-hold idea applies for most people. I recently stumbled on an article by Henry Bloget that both opened my eyes, and confirmed my suspicions in the following: Market timing and the longevity of one’s investment horizon matter much more than they are given credits for. Since I can hardly put it any more eloquently than Mr Bloget, I am quoting his 2004 article. If you have some time, the entire series of articles are well worth a read.

In the financial markets, the “long term” is long. Over the past 200 years, U.S. stocks have, on average, returned approximately 10 percent a year (about 7 percent, after adjusting for inflation). For many of those 200 years, however, stocks have returned nothing—or worse. The fallow periods, moreover, have not just lasted months or years. They have lasted decades. In a 2001 Fortune article, Buffett observed that the 20th century encompassed three major bull markets in which the Dow jumped more than 11,000 points and three major stagnant markets in which the Dow lost 292 points. The three bull markets, in aggregate, lasted 44 years; the three bear markets 56 years. For more than half of the century, in other words, stock performance stank.

The most recent market cycle spanned 34 years, from 1966-2000. The bull phase, the one we all remember, lasted 18 years (1982-2000), and it took the Dow from just over 800 to just under 12,000. The bear phase—the one almost no one remembers—lasted 16 years (1966-1982—16 years!), and it took the Dow down nearly 20 percent. Lest this tempt you to rush out and buy bonds, average bond returns from 1966-1981 were worse than those on stocks (bonds can be dangerous when inflation is rising, a fact worth remembering now).

Essentially, the message here is that markets cycle swings are much longer, and sometimes, steeper, than we are led to believe. Therefore, if you pluck your money down in the stock market, be prepared for long and sometimes breathtakingly volatile returns. Ultimately, most of us do not have this kind of time horizon when it comes to our money. Many needs arise that range from getting married to having children, from buying property to dealing with unexpected health issues. And given the uncertainty of the market to move consistently upward in the medium-term, its actual liquidity is in fact much lower than commonly perceived. Therefore, the stock market might not be the appropriate default deposit for our hard-earned money.