Hold on – and keep down the risk of losing out with equities

Over the long run, equities have enjoyed handsome returns, but does it follow that “buy and hold” invariably delivers for investors? Is it the case that good investment is all about time in the market, rather than timing the market? What kind of long-term returns are realistic? And if markets go pear-shaped, how long might investors have to wait before they are back in the black?

The buy-and-hold camp point out the US stock market has returned average annual returns of more than 9 per cent (6.3 per cent in real terms, adjusting for inflation) since 1900.

In real terms, $1 invested in stocks in 1900 would have been worth $951.7 last year, compared to just $9.40 for bonds.

Sceptics, however, note the 21st century's miserable returns. According to London Business School professor Elroy Dimson, co-author of the annual Global Investment Returns Yearbook , real global equity returns averaged just 0.1 per cent between 2000 and 2013.

Bad as returns have been, most market-timers habitually do worse. US fund outfit Vanguard recently noted its clients tended to buy high and sell low, recording annual gains of just 2.67 per cent over the past 15 years, compared to 4.58 per cent for the S&P500.

A US study of 66,000 investors between 1991 and 1997 found the most active traders earned 7 percentage points less annually than buy-and-hold investors.

Countless studies confirm the vast majority of fund managers also underperform the overall market, in both bull and bear climates.

“The risk of losses declines as investors extend their holding periods,” says fund giant Blackrock. Since 1890, investors suffered losses in 23 per cent of five-year periods and 14 per cent of 10-year periods. Equity investors enjoyed positive real returns “in almost any 20-year period”.

Stagnation
Nevertheless, long periods of stagnation are not uncommon. Between 1900 and 1920, the Dow Jones Industrial Average went absolutely nowhere. It went skyward in the 1920s before crashing in 1929. By 1948, it was still 50 per cent below that infamous peak and did not hit new highs until 1954 – a 25-year wait.

Another major bull market ensued, only for famine to strike again – at the end of 1981, the Dow was no higher than it had been in 1964. The index enjoyed an astonishing 15-fold increase between 1982 and 2000 to be followed by another lost decade.

"We had three huge, secular bull markets that covered about 44 years, during which the Dow gained more than 11,000 points," as Warren Buffett once put it. "And we had three periods of stagnation, covering some 56 years. During those 56 years the country made major economic progress and yet the Dow actually lost 292 points."

Now, these figures are far from the full picture. They do not account for dividends, for instance, the source of the bulk of investor returns over the last century.

Include dividends, and the Dow was actually at a new all-time high in 1945, not 1954. Despite losses of 89 per cent between 1929 and 1932, investors who stuck it out were eventually made whole. Similarly, as noted earlier, reinvesting dividends meant US investors invariably beat inflation over 20-year periods.

Still, buy-and-hold advocates can also be accused of cherry-picking data. As Prof Dimson has noted, the evidence that stocks beat inflation over all 20-year periods is based on “relatively few non-overlapping observations and is hence subject to large sampling error”.

More crucially, the “stocks for the long run” argument is almost always based on US data. The US, of course, was the big winner of the 20th century. Excluding the US, real global returns averaged just 4.4 per cent. Other countries fared much worse.

Global picture
Take Russia. In 1900 it was the seventh- largest equity market in the world, having comfortably outperformed the US in previous decades. The 1917 revolution, however, wiped out investors. Three decades later, Chinese investors suffered the same trauma.

Extreme cases? Yes, but there are many other sobering examples. The 20th century saw France, Italy, Austria and Belgium all suffer periods of 60 years or more where equities failed to keep up with inflation. (Austrian equities saw real returns of just 0.6 per cent over the last 113 years). Japan, Germany and Spain have all suffered 50-year periods where stocks lagged inflation.

The US, Dimson's data shows, is very much the exception – only three other countries have "never experienced a shortfall in real returns over a 20-year period". The most dramatic such example in recent decades has been Japan, the Nikkei falling from a peak of more than 39,000 in 1989 to just over 14,000 today.

Risk-averse investors might prefer bonds, one might think, but that would be a mistake. In the US, average bond returns were poorer than equities during the equity drought between 1966 and 1981. The 2012 Global Investment Returns Yearbook notes that six of the 19 countries studied – Germany, Italy, France, Belgium, Finland and Japan – saw negative real returns over the entire 1900-2012 period.

For the first 80 years of the 20th century, bonds had negative real returns in another eight countries, meaning investment in government bonds “destroyed real wealth” in 14 of 19 developed markets.

Timing
Yes, stocks win over the long run, but it can be a very, very long run. Legendary money manager Jeremy Grantham takes a long-term view, but believes value is crucial. Market timing "is a tag some buy-and-hold investors use to put down anything that involves using your brain", he said in 2009.

“We were overweight emerging markets for 12 years, because they were cheap for 12 years. And when they get expensive, we get out. I call that sensible asset allocation based on risk and return.”

For Grantham, buy and hold is a "very low hurdle. If you have no time and are completely traumatised and are thinking about finances, then buy and hold some index and throw away the key . . . But if you haven't learned in the last 10 or 15 years that the market is capable of being utterly crazy, then you've learned nothing".

Grantham’s value philosophy is borne out by the figures: very expensive markets tend to be followed by long periods of underperformance, and very cheap markets go on to deliver the goods. In essence, be fearful when others are greedy, and greedy when others are fearful, as Buffett likes to say.

However, it’s also a fact that very few investors beat the market, having neither the knowledge nor the stomach required to do so.

The buy-and-hold case may be overstated, but most investors are likely best off sticking to it anyway.

With individual stocks, buy and hold is a gamble. Sticking with individual countries, as we have seen, is also risky. Clearly, diversification is essential. A global basket of stocks earned real returns of 5 per cent since 1900, with outperformers like Australia and the US compensating for the many underperformers and the occasional outright disasters.

If having a responsible and well-diversified portfolio is key, so is an appreciation of the reality of long-term equity returns, which are lumpier and lower than is commonly assumed. Investors banking on stellar returns as long as they hold on for 20 years are optimists, says Dimson. The lesson of history is simple: “Their optimism is irrational.”