One of the age old question is whether or not to manage your own investments.
You’re probably suspect of an article evaluating the question by someone who makes their living by overseeing their client’s investments. I can say that over the years of evaluating both sides, I have come to the conclusion that both options are valid depending on the type of person that you are. Hopefully this article will give you more insight as to which side you may choose to fall on.
Although there are many investment philosophies and options, I would categorize them into two major camps. The first I call the buy and hold approach to investing. I would describe buy and hold as an investment philosophy that uses a static percentage for each asset type. At the broadest level, this predetermined allocation is usually between the percentage of stocks or stock mutual funds and the percentage of bonds or bond mutual funds.
Inside the categories of stocks and bonds are sub asset types. For stocks, they may be international versus domestic, the size of the company, or the style of investing. For bonds, it may be relate to maturity lengths or bond types.
In a buy-and-hold investment strategy, at any particular stage of life, the percentage of a portfolio allocated to each of these different types of assets and sub assets remains relatively unchanged. Of course a mutual fund manager may not be buying and selling companies over time inside of the fund, but actual mutual fund owned remains in the portfolio indefinitely.
The value proposition of a buy-and-hold investment strategy is that there is a high level of diversification among the different asset types chosen so that although the account value will go up and down over time, the different types of assets represented will complement one another so that when one zigs the other will zag. Also, since it is a long-term strategy, the ups and downs will work themselves out with a long-term upward trend in the market over the years.
In contrast, a tactical approach to investing finds value in dynamically adjusting the amount or percentage dedicated to the different type of assets in a portfolio. If a buy-and-hold approach maintains a static 60% in stocks, a tactical approach may reduce or increase the percentage in stocks throughout the year if the investment model calls for it.
Tactical investing also increases the number of asset types used in a portfolio. If a buy-and-hold philosophy uses just stocks and bonds, a tactical approach may also include asset types such as real estate and commodities. The purpose of introducing additional asset types is that they have a lower correlation or relationship and may better stabilize and balance a portfolio over time than using only the asset types of stocks and bonds.
Put together, this tactical approach allows a dynamic execution of increasing or decreasing exposure to multiple asset types depending on the current momentum of each asset type. Many tactical approaches also allow managers to retreat to safe assets such as cash in the event of market meltdowns.
Each approach has both advantages and trade-offs.
One of the advantages of the buy-and-hold investment philosophy is that during a positive stock or bond market, the portfolio has a high probability of capturing much of this upside. Because of the high degree of similarity and correlation to funds inside each asset class, simply having exposure to that asset class allows an investor to capture market increases in that sector. For example, nearly all large growth mutual funds will have a relatively similar performance to the S&P 500 during a time period that this index has growth.
The converse of this advantage also holds true. Maintaining exposure to a specific asset type during times of market weakness and loss will nearly always expose the investor to these losses as well. As an example, nearly all large growth mutual funds will go down to the same degree that the S&P 500 index goes down over the same period.
As our markets grow more and more interdependent and especially during market meltdowns, there is less and less true diversification in the different types of stock mutual funds available. As an example, during 2008, it didn’t really matter whether you owned small, medium, or large size companies in the form of stocks or stock mutual funds, all sectors went down significantly.
So on the positive side, a buy-and-hold investment philosophy can do significantly well during time periods of strong market performance, but on the negative side, this same philosophy can suffer during bad markets. There is, in essence, no risk management built in.
In a buy and hold philosophy a small growth mutual fund manager can only invest in small growth companies. If small growth companies are out-of-favor, there is nothing the mutual fund manager can do to invest in alternative company types. In addition, if all stock asset types are out-of-favor or declining in value, mutual fund managers generally do not have the discretion to move to safe assets.
A tactical investment management approach, which employs more flexibility also has its positives and trade-offs.
One of the potentially significant positive results of tactical investment management is that it can smooth out the large swings of volatility that occur during bear and bull markets. When managers are free and flexible to increase or decrease exposure to different types of assets and to include alternative assets beyond stocks and bonds, they may be able to dynamically avoid areas of the market that present the most risk and loss.
This approach can provide a higher level of consistency from year-to-year.
One of the biggest trade-offs that investors must embrace, expectation-wise, when using tactical investment management is that it can lag the market during times of strong performance since it is more highly diversified than the traditional stock market. On the other hand, effective tactical managers can improve their value during times of extreme market weakness by dynamically avoiding the assets producing losses. The investor must take a long-term perspective and approach when using tactical investment management, recognizing that much of the value provided takes place during times of market weakness rather than market strength.
Finally, professional tactical investment management will have a higher expense per year then the buy-and-hold investment approach.
How should an investor evaluate the effectiveness of each approach to determine which brings more value?
It is important when comparing the two approaches to not use performance alone nor expenses alone in the evaluation process. Performance must be taken into account, but should be evaluated over an entire market cycle that includes both a bear and bull market. Second, after-expense performance should be compared so that it is apples to apples.
But performance is not the only criteria to use when comparing the investment philosophies side-by-side over an entire market cycle. Just as important is the level of volatility and risk (as measured through standard deviation) and the maximum loss that the portfolio experienced. Given similar performance, one would gravitate to the philosophy that provides a more consistent and less volatile experience to the investor.
Having experience as an investment advisor in working with retirees, a boring portfolio without high levels of up-and-down volatility has great value, especially for the retiree who is systematically withdrawing money from accounts to produce retirement income. If investors experience simultaneous investment losses at the same time as systematic withdrawals, the longevity of their portfolio comes into serious jeopardy.
As we are living longer, we need an investment approach that provides the highest level of financial security for retirements that can last 20 to 30 years.