Buy and hold no more?

Baruch has long held that the academic finance industry has produced nothing of lasting worth. Or at least nothing that has helped anyone make money consistently, which is, after all most of the point of the exercise, isn’t it? In fact the impact of the academics on markets has probably been on balance pernicious, contributing to overconfidence, instability and perdiodic crisis as much as it has shed light on the inner workings of anything. I’m thinking of course of Black and Scholes, portfolio insurance, hard Efficient Market theories and the large number of ” new paradigms” we have had in the past 30 years, which invariably ended in disastrous crashes, with yet looser money in their wake and another round of inevitable “new paradigms”. All of them, I guarantee you, had the solid imprimatur of some finance professor somewhere or other.

It is not all hopeless, however, because the academic study of finance has also produced Andrew Lo, whose “adaptive market hypothesis” seems to Baruch to sum up better than most how things actually work. Insofar as Baruch understands it, the general idea borrows from biology and behavioural economics. It is that markets are crucibles for evolution and adaptation, like an ecosystem, and while they can be efficient they are so only periodically and then only in bits. Strategies that work well will only do so for a time; only punters able to identify changes in the environment rapidly enough and (more difficult perhaps given the current animus against “style drift”) able to adapt their style of investment to profit, or at least not blow up, will survive. That, by the way, survival, appears to be the name of the game in the adaptive market; sticking around long enough to make it to retirement. It’s not an easy place to hang out in. As Spinoza was fond of saying, we also know this from experience to be true.

The point is, I always watch out for something from Lo and read it avidly. I was therefore very surprised to find myself disagreeing with something he was saying in an interview with CNN Money (HT I am sure either Josh or Tadas, like everything else), which was that the increased use and democratisation of technology in financial markets has led to higher levels of volatility and instability that make “buy and hold” no longer viable:

Buy-and-hold doesn’t work anymore. The volatility is too significant. Almost any asset can suddenly become much more risky. Buying into a mutual fund and holding it for 10 years is no longer going to deliver the same kind of expected return that we saw over the course of the last seven decades, simply because of the nature of financial markets and how complex it’s gotten.

Baruch worries that Lo, while likely spectacularly right in general with his highly convincing theory, may be wrong in the particular here. 

To start with, since when has the increasing use of technology NOT been a feature of financial markets? We can say it has intensified, but has it really? Moreover, I simply don’t think the extreme volatility of the past few years has been due to automated trading and ETF profusion, as much as it has been to external, economic shocks. I would also include the long term consequences of e.g. the demutualisation of the banking system, the fact that bond investors are not too bright, Alan Greenspan’s curious ideas and the unquestioning veneration they were held in, the pusher-addict relationship between the US and China in exports and bonds, and, most recently, the inherent contradictions of European Monetary Union. Blaming the humble algo-bot in the face of all that seems a little extreme.

In fact I can only think of two examples of clear technology-led instability in the past 10 years, the August 2007 Implosion of the Quants (which I am sure most everyone has forgotten) and the Flash Crash of 2010. In the first case, directional, fundamental investors like myself hardly noticed that anything was going on at all. The Flash Crash, while scary, was largely over in 45 minutes and markets resumed their stately course very quickly afterwards. That’s not to say we won’t have a worse or more lasting technology-created crisis in the next few years, just that we haven’t had one yet.

In fact, at least over the past few months, the thesis of the death of “buy and hold” has been quite wrong. Buying and holding has been exactly the right thing to do. Implied volatility has dropped like a stone, creating a performance millstone for those who, conditioned by the last few years, have tended to stay long it. Stocks have been great investments and have hardly hiccoughed at all. Admittedly, this is too a short time period to base a thesis on, but isn’t it possible that there could be a period ahead of us of lower volatility, fewer crises — or let me rephrase that — a period of a more sanguine response on the part of investors to instability?

After all, we’ve been through quite a lot these past few years, and the world hasn’t come to an end; we’ve all kept on buying iPhones and stuff, China hasn’t imploded, we can still pay for things in Euros. Lots of us still have jobs, and it looks like more people are joining the workforce every month in the US at least. It might be that investors have realised that things are pretty well. . . OK, that stocks are cheap, bonds are pricey, and maybe we could think about going on a more expensive holiday again or getting a new LCD TV (have you seen how cheap they are these days, dear?!) for the kids’ bedroom. Despite what we have lived through recently, history shows that markets like this have have been the norm, not the exception, over the long term.

You could even put this thought in an adaptive market context — that we might be having a change in the environment. After years of instability those investors who are left are those who have learnt how to profit from volatility, from choppy markets and from taking crises seriously and as a result are way too used to it, and there are too many of us like this. They are not positioned for a period of calmness, of things getting generally, modestly, better, for a market where buy and hold can work. They need to adapt again, or if not die, then potentially stagnate. Of course, Lo could be right and something nasty is coming this way next week. But from my understanding of his Adaptive Market Hypothesis, I don’t think he can be so certain of it.

Baruch’s mind keeps coming back to a post he wrote in May last year, where, drunk on a re-reading of Peter Lynch’s One Up on Wall Street, he suggested that it may be time for individual investors to try their luck again in single stocks and over the next 6 months researching a long term portfolio of 5 or 6 names. Baruch is extremely surprised to see how well that has worked out so far. Perhaps he was on to something after all? Put me in David Merkel’s camp on this one, not at all a bad place to be.

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7 responses to “Buy and hold no more?

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  4. Baruch,

    I am symapthetic with the idea Lo was trying to get across, but think he used an unfortunate choice of words. I think he prolly meant that in the context of extreme vol and an environment where avg vol is secularly increasing, buy and hold is sub-optimal, and I think he meant it at the asset class level, perhaps self-servingly, in the context AMH and his strategies on offer at Alpha Simplex where he can (of course for a price) offer investors something ummm errrr more optimal, rather than the individual stock level. In the simplest sense this just means selling (for an interval) and then buying back and holding (again, for a bit), and doing the same across asset classes. And insofar as fewer large managers are presently doing this systematically, and ignoring the benefits to one’s stomach, it is reasonable to believe that done well, this might indeed be more optimal. For a while.

    The problem is, of course, what happens when what is optimal today (because it is fringe) becomes mainstream via adoption due to its prior optimality? “Oh dear” indeed. If one thought the present unstable, imagine what it might like when a great number of elephant investors with leverage decide that rear-window gamma negative risk-parity-like allocation and rebalancing is better than a forward-looking, gamma positive approach.

    Perhaps things these do not and will affect you, as one who is agnostic to such things macro, and focused upon cash-flows, growth, innovation and obsolesence. Perhaps such a maelstrom will barely be a blip on your radar. But I think not. I think (like you and David) it will open opportunities for the long-frame principal investor (such you and I), if not for the opportunistic agent-manager. The question though will remain: what will you do when the others recognize the opportunity you in fact seized, and makes their values pedstrian at best, or precipitous at worse, irrespective of how wonderfully such stocks may meet criteria for the longer-run?

    • Well Cassandra, the problem you point to is exactly what is on my mind. It may be that we have had the environment shift under us to make a long gamma approach more of a headwind.

      In any case you are right, it does affect me, because there is no such thing as macro-agnostic and I think anyone who has survived this far has to have either a non-fair share of luck or has been running a portfolio that can survive any of the possible shocks that smart people have been warning us about for some time now. A portfolio like that will underperform peers who damn the torpedoes and steam straight ahead. If that environmental shift has indeed happened I need to change my approach, to “get stupid” again. When the time comes to change again, and when that strategy gets over-populated, well, I just hope I can read the tea leaves before it is too late.

  5. Buy and hold doesn’t help the masses, who only have savings in 401(k)’s which only offer mutual funds. The most he can do for them is deter them from acting foolish, by trading like a manic-depressive, which leads to the old saw that stocks do 10%, stock mutual funds do 9%, and mutual fund investors do 4%.

    And Lo’s off the shelf strategies for retail investors aren’t so hot. Check the performance. Sideways, like the over-rated John Hussman.

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