TradingGods.net

The Allure of Buy-and-Hold Investing

Buy-and-hold investing has the allure of the System 1 tasks that so dominate our lives.

 

By 

 

When we think of our lives or just talk about what we have been doing lately with a friend, we tend to focus on big events. If we have just taken a trip, the details will be recounted. If a baby has been born or we’ve been to a wedding, the event dominates our conversations. Similarly, in the news, an uprising in Iraq or the World Cup can consume the headlines and color what we think is occurring around us.

But really, life is more often concerned with simple tasks, with everyday activities. We walk to the mailbox. We drive to the store. We eat our meals at predetermined times. We sleep.

Behavioral scientists or psychologists tell us that these actions are controlled by what Nobel laureate Daniel Kahneman calls System 1. System 1 is our subconscious, automatic response system that takes us pretty smoothly through each day without a lot of conscious thought about how we do it.

Retirement Day Trader - eBook

Sign up for our Newsletter & get the FREE eBook
Retirement Day Trader:
How to Sell Weekly Options for Steady Income

  • This field is for validation purposes and should be left unchanged.

Unless you are 6 months to a year old, you don’t give much thought to the mechanics of how you get up on two feet and walk. Unless you are a student in driver’s ed, driving is fairly effortless. And don’t get me started on how easy it is to eat! Now sleeping—it seems the older you get, the more effort it takes, but, generally, if you get tired enough, you just fall asleep.

Buy-and-hold investing has the allure of the System 1 tasks that so dominate our lives. You invest once, you allocate among asset classes to diversify away risk, and—other than an occasional quarterly or annual tweak back to that allocation—that’s it. The markets take care of the rest.

System 1 is very efficient. It handles most tasks … most of the time. But what about reason, logic, and responsiveness? Don’t they come into play? That’s the job, in Kahneman’s view, of the mind’s System 2. It steps in to use those faculties only when System 1 needs its help.

You’re walking along and the sidewalk ends. What do you do? You can’t just continue to follow System 1 and keep automatically walking, can you? You might be lakeside or, worse still, on the edge of a cliff. A decision has to be made.

You’re driving your car when a big, diamond-shaped orange sign appears on your right-hand side: “Detour.” Suddenly, you need more than just an automatic pressure on the accelerator, hands on the steering wheel, and brake at the ready. You need to think about what to do next.

This even happens while eating. You’re automatically eating your salad. Fork to lettuce, fork to mouth, chew, repeat.

Then, soup comes. You prepare to repeat the process—but now with a spoon. You pick up the spoon, dip it in the soup, and bring it to your mouth. All this without a single conscious thought. The soup touches your tongue. You recoil—it’s too hot! Do you really want to keep consuming it right then? You have to think about it.

Finally, sleeping seems automatic. What could be more passive? You just have to lie there, right? But that’s an illusion. You have a bad dream. Doesn’t System 2 have to convince you that that’s all it is? A crack of lightning awakes you. A summer storm has sprung up in the middle of the night. “Do I have to close the windows?” There’s a noise downstairs, the dogs start barking. You awake. Is a trip downstairs to investigate necessary?

These are all simple tasks, and we spend most of our lives automatically carrying them out without even thinking about them … most of the time. But they have one other characteristic: They are all responsive to change.

In every case, these simple tasks still require a contingency plan. They must be ready to respond to the environment around them … especially surprises!

In “Thinking, Fast and Slow,” Kahneman tells us that “the main function of System 1 is to maintain and update a model of your personal world, which represents what is normal in it. The model is constructed by associations that link ideas of circumstances, events, actions, and outcomes. … As these links are formed and strengthened, the pattern of associated ideas comes to represent the structure of events in your life.” Yet, he also tells us that “a capacity for surprise is an essential aspect of our mental life.”

As I write this article, I’ve been trying to think of an ordinary activity, some simple task we do, that does not require that we also have the capacity to deal with a surprise while we are carrying it out. (Let me know if you think of one. I haven’t.)

Still, most of the investment world seems to be forever trying to convince us that investing is somehow different. The “buy and hold” mantra is chanted on the financial shows and printed repeatedly in both the financial and nonfinancial press.

I guess they would respond, “But investing isn’t a simple task.” And that is true. But does that lead to the conclusion that the way to deal with even a non-simple task is to abandon the use of System 2 when a surprise occurs?

Of course, the buy-and-holders, the advocates of passive investing, would respond that they employ System 2 before they invest. But isn’t that the same as thinking about where you are going and what you are going to wear before you leave on your walk, and then ignoring System 2 completely once you’re dressed?

Couldn’t that lead you to automatically proceed into the lake when the sidewalk unexpectedly ends? Like the buy-and-hold-investing argument, you’re “all wet” as a result.

In contrast with passive investing, dynamic, risk-managed investing always has a plan to deal with contingencies. This type of active investing is generally responsive investing. It is designed to deal with routine, day-to-day events but also has the ability to adapt to its surroundings and plans on surprises.

Dynamic, risk-managed investing models are designed to generate better long-term performance. They seek to accomplish this by emulating, not rejecting, our everyday experience with life’s simple tasks—letting System 1 carry you along for most of the time. But these models also are built to engage System 2 when surprises inevitably surface.

Market update

Easily the biggest surprise last week was the disappointing earnings report for Facebook (NASDAQ:FB) and the resulting plunge lower in the price of its stock. The one-day 19% decline, the resulting biggest daily loss in market value by a company in history, and CEO Mark Zuckerberg’s personal loss of $15 billion led the news and were all surprising. Good thing he’s been a net seller over the last two years.

Facebook Stock Sales Last two years

This oft-touted “one-decision stock” turned out to be a perfect illustration of why buy-and-hold investing can be painful. Yet, at least two market commentators during the preceding week had responded to negative signals they had seen that suggested action beforehand.

Also, despite the recent new highs by so many market indexes in the last few weeks, surprisingly, many indicators were quick to flip to a sell on last week’s tech sell-off in reaction to the Facebook news. Breadth and new highs both began to look more unfavorable. One of my favorite indicators—NASDAQ(NYSEARCA:QQQ) vs. S&P (NYSEARCA:SPY) relative strength—also turned south.

Here’s another negative log to add to the fire: August over the last 20 years has been a loser, on average. Even when we enter the month higher year to date, the market has managed to lose money during the last full month of summer. And, of course, August is followed by September—the only month averaging negative returns over the last 20, 50, and 100 years.

The market indexes continue near all-time highs, however. They even gained ground on most indexes last week, despite the Facebook surprise. Neither bonds nor commodities fared as well.

While the S&P 500 has yet to overtake its January 24 all-time-high point, it did get within a percent or two last week. It even broke out from its previous resistance point of 2,800.

S&P 500 Last 12 Months

Small investors certainly have not bought into the recent market highs. Last week, they continued to increase their bearishness. But as a contrary indicator, this is actually bullish for stocks.

Economic reports failed to live up to economist projections last week. Twelve of the 18 reports did not reach the levels projected. At the same time, in contrast, close to 70% of earnings reported outperformed analyst predictions as we hit the halfway mark in earnings reporting season.

Although interest rates have been rising, it was encouraging to see S&P 500 price performance outperforming bonds again, as the index comparing the two broke out to new highs. In the past, such a breakout has generally brought on further gains for stocks.

Relative Strength of S&P vs Long-term Treasuries

Still, all in all, it continues to be a mixed picture at this point in the summer for the equity markets. This makes it especially dangerous to (1) be in a buy-and-hold strategy or (2) try to make market-timing judgments on news events. Better to let the time-tested strategy signals employ System 2, disciplined reasoning to choose the best intermediate-term course of action every single day.

Disclosure: No communication by Dynamic Performance Publishing or our employees to you should be deemed as personalized investment advice. Any investment recommended in this newsletter should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company. Dynamic Performance Publishing, its affiliates, and clients may hold positions in the recommended securities. Results are not indicative of holdings for clients of Flexible Plan Investments. Forwarding, copying, or otherwise duplicating this information for the use by anyone other than the intended recipient is expressly forbidden. These results are not representative of those achieved by clients of Flexible Plan Investments, Ltd. (FPI) due to differences in security selection, timing of trades, transaction fees, and FPI’s management fees.