Many investors recognize that, on average, investment strategies that rely on stock selection and market timing result in lower returns and higher risk than buying and holding a security that tracks a market index (an index fund or ETF).

This then begs the question of whether investing is simply a question of buying and holding certain asset classes.  The answer is no and here are three reasons.

1. The idea of holding different assets to diversify is almost commonplace. But what exactly is an asset class? Bonds and equities both have a positive expected return, and respond differently to different economic trends. A mix of bonds and equities is likely to give a higher return per unit of risk than either 100% bonds or 100% equities. So, bonds and equities, as broad groups certainly qualify.  What about real estate, commodities, small company equities, preferred shares, emerging market debt or emerging market equities? Deciding whether different securities are a useful asset class and what percentage is appropriate in a portfolio is the subject of continuing research. For example the work of Fama and French (1993) has established small companies and value companies as distinct asset classes. This means that portfolios with a higher exposure to these asset classes than the market will have a higher return. At PWL Capital we have access to extensive historical datasets which helps test the impact of different asset mixes.
2. Should an investor hold a fixed asset allocation for life? If not, what factors drive changes in the asset allocation? Certainly the older we become the less opportunity there is to recover from market declines which makes us more risk averse. Other factors such as the volatility of future earnings can also change an investor’s ability to take risk should be reflected in the asset allocation. For those of us who are withdrawing from investments to provide an income in retirement, it is expected that the percentage of more risky assets (equities) decreases with age, leading to the idea of a personal “glide path”. These glide paths will vary according to individual circumstance but there is no generally accepted model.
   
   Making sure that a portfolio can deliver a future income stream (increasing with inflation) also imposes changes on the current portfolio composition. For example, it is easy to see that if you wanted to buy a house in 5 years it would make sense to invest in an asset class that tracks house prices between now and the purchase date to ensure that you maintain the real purchasing power of your funds. Designing portfolios for stable future income flows is more challenging than investing for capital growth and requires a dynamic asset allocation.
3. The final problem with buy and hold is that asset prices vary with time. Consider for example, two asset classes, US stocks and US bonds. An investor holds 60% Us stocks and 40% US bonds as their long term (strategic) asset allocation and the total market of US stocks and bonds is such that stocks represents  60% of the market. Thus, the investor has the same risk as the overall market. 
   
   Suppose the US equity market falls by 20% and the bond market is unchanged in value. The investors new  asset allocation is now 55% stocks and 45% bonds. How is the investor to respond? A buy and hold investor would take the long view and do nothing, figuring that in the long term equities would recover.  But as the economist, Maynard Keynes (1923) taught us, “in the long run we are dead”. To rebalance back to the original asset allocation of 60% equities requires adopting an equity exposure greater than the overall market, taking on significantly more risk. Recently, Sharpe (2010) has suggested an adaptive allocation policy for re-balancing.

In summary, “buy and hold” fails to:

• help choose the optimal mix of assets,
• accommodate changes in asset mix to address changing circumstances and the need for retirement income,
• or provide a means of reflecting  the change in market values of different asset classes.

The idea that using low cost, tax efficient ETFs and index funds is a passive, “buy and hold” strategy is a misconception. This confusion is often promulgated by active managers of retail mutual funds who, because of their broad investment mandates, make it almost impossible to control the portfolio asset allocation. Perhaps using these active mutual funds might be classified as “Buy and Hope”.