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Investing

In defense of the buy-and-hold strategy

January 9th, 2017 by

The truth about passive investing

 
 
 

The year was 1983 and Madonna had just released “Holiday”, a cheerful song with a catchy tune. But what hooked me was her wavy hair in the music video. I made a silent vow: 1983 would be my summer of great hair. I already mastered Madonna’s eclectic thrift store wardrobe. The only thing missing was her swingy, wavy hair. 

So I booked a perm at a cheap hair salon in downtown Toronto. Perms were like the index funds of the 80s. The de facto answer to, “What should I do?” that my hair not the ideal texture (being curly already) for a chemical perm deterred neither myself, nor the stylist. Two hours later I walked out with a wide halo of auburn candy floss on my head. Two days after that I got an army-style buzz cut because my nuked hair was shedding like a chow-chow. Good-bye summer of great hair. 

Getting that perm was a bad investment decision. I should have maintained the status quo; my hair was already pretty wavy and swingy. Instead, I went for exuberant optimism and got fried in the process. 

Maintaining the status quo

In behavioural finance, status quo is considered one of six emotional biases that can trip up investors. Similar to inertia, when in the grips of status quo bias an investor is liable to hold onto securities simply because they are familiar or because they have grown fond of them despite poor performance that may compromise financial goals. 

While being a slave to any kind bias is never a good thing, investors today live in an ecosystem that encourages frequent trading—the opposite problem of status quo. The constant barrage of business “infotainment” programs, investing information, and what Lowell Miller, portfolio manager and author of The Single Best Investment, calls the three sirens (fear, greed, conformity), gives us both subtle and overt pressures to transact. Add to this the transparency of equity pricing and the ease with which trades can be executed and you have a recipe for trouble. 

As humans we seek novelty and stimulation. This explains why holding is often the hardest part of investing, particularly during periods of high volatility. We read about a promising company in the paper and wonder if we shouldn’t sell a current holding to buy shares in it. When paranoia strikes we question whether our investment manager selected the equities in our best interests or in hers? It’s hard to just sit there, so we pick up the phone and make a trade. The more often we succumb to this habit, the more we become traders, not passive investors in a growing business. 

Know the difference between passive and inactive

There are legitimate occasions when a portfolio needs to be tweaked. Some examples are when a stock has gotten ahead of itself and may represent too large a proportion of the portfolio; the need to rebalance back to a strategic asset allocation; taking advantage of short-term industry cycles for tactical asset allocation; and when the investment thesis for holding a stock has changed. 

Contrary to the popular belief that being “passive” means doing nothing, holding onto an investment takes a great deal of stamina, courage, and strength of character. Constantly second-guessing our investment decisions and frequent trading increase our feelings of anxiety and decrease our total investment returns. One study showed that, in 2000, the portfolio turnover rate for individual investors on the NYSE was 75 per cent and this shaved 5.9 per cent from their returns. Another way to put this is, an investment would have to do better than nearly 6 per cent just to break-even. 

Back to basics

Albert Einstein said, “Everything should be made as simple as possible—but not simpler.” Being a good investor in all kinds of market conditions is not simple, but the process should be made as simple as possible. In others words, as with many things in life, we should endeavour to get out of our own way. As my hair fiasco proved, every decision is an opportunity to get it wrong. 

 

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