The Risk of “Buy-and-Hold” Nobody Is Talking About

BY JOHN MAULDIN

Investment advisers say we are “investing for the long run” and diversify among low-fee funds in various asset classes and indexes.

Then they trot out studies showing investors will average 8% or whatever in the long run. And those are true statements.

The problem is that most investors don’t have the 40 or 50 years those studies cover. And they have to experience the bear markets along with the bull markets.

The estimates also vary depending on when the study starts. The market, for example, can be in a bear cycle for 20 years before recovering. If you entered the market in this stage of the cycle, your portfolio would be devastated.

We are now in one of the longest running bull markets in history. And it is not clear how long this bull market will continue. No one knows the future.

But I do know this: we will eventually have a recession. And the bear market that comes with it will be brutal, like all bear markets are during recessions.

I think the next recession will likely see a bear market loss of at least 40% if not 50%. As I’ve written before, high total US debt means the recovery will be even slower this time.

If you are over 55 or 60 years old, your “investing for the long run” could seriously slash your retirement income. Or push your retirement off for years as you try to make up what you lost in the bear market.

And the investment advisor or strategist who told you to use a buy-and-hold strategy will simply shrug it off and say something like, “I am sorry. But we can’t predict the markets. It’s just bad luck we had a recession and bear market.”

That’s because they did not disclose the true cost of your buy-and-hold strategy, and the hidden cost of your low-fee funds.

Here’s the Real Cost of Long-Term Investing

Sir John Templeton and a number of others teach us to remember that bear markets always follow bull markets, and vice versa.

You should always expect the change and decide what you’ll do in advance.

Let’s say you’re down 50% after a 10-year bull run. The actual cost of that low-fee fund was 5% a year for the risk you took.

But nowhere in the disclosures is there any indication you should be budgeting for this cost. If you add in 5% total cost to your low-fee system, all of a sudden, the costs seem pretty high.

You would have never bought it knowing that you would pay 6% or more. But that is essentially what you did.

Whether you are paying those fees incrementally or all at one time during the bear market, the results are the same. But the investment advisor will say the markets will come back and you will be okay.

That may be reasonable advice if you are 30 years old, but not if you’re 60 or 65.

You Must Have a Quantifiable Hedging Strategy

Bluntly, a buy-and-hold strategy without an appropriate hedging strategy is lazy. The next bear market will devastate pensions and retirement accounts for the vast majority of investors.

But it can be avoided.

I argue that you should hedge by having a diversification of trading strategies. But that is just one of a half dozen different ways to hedge your portfolio.

I was on a TV set with my friend David Tice (formerly of the Prudent Bear Fund). His favorite way to hedge is simply buying put options for your portfolio.

I know one manager running multiple billions of dollars that has been doing that for almost 20 years, and his total performance through a cycle simply outperforms any buy-and-hold strategy I’ve seen.

He also underperforms during a bull market, as hedging costs real money. But when he makes money during a bear market, the real “cost” of his strategy is soon revealed.

If you are a smaller investor and can’t get an investment advisor who can hedge for you, then simply use the 200-day moving average. When your funds drop below their 200-day moving average, exit to cash.

If it’s a real bear market, you will be in cash for the rest of the drop and then you will be able to buy back in closer to the bottom.

But the important thing to do is to plan your hedging strategy in advance. It must be automatic and quantifiable.

And recognize that you must have a risk budget. Risks and the losses that accompany them are part of the total cost of investing and managing money.

The regulatory authorities are properly focused on having advisors and brokers disclose the total costs of their management to their clients. But nobody calculates the cost of risk, nor do they include it in the documents.

First off, it is unknowable. Will a bull market last for four years or eight years or 10 years or 12 years? No one knows. How deep will the bear market be? No one knows. So, it’s very difficult to actually estimate a cost upon future facts that no one knows today.

That being said, I can tell you there is going to be a recession and a bear market in the future. And it is going to exact tremendous cost upon your equity portfolios.

Telling you exactly what that cost will be? I don’t have a true clue except looking back in history, and that tells me losses of 40–50% (or more) are quite possible. Ugh.

If you don’t have one, at least begin to figure out what your hedging strategy for the future will be. There will come a day when you will be happy you did.

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Sharp macroeconomic analysis, big market calls, and shrewd predictions are all in a week’s work for visionary thinker and acclaimed financial expert John Mauldin. Since 2001, investors have turned to his Thoughts from the Frontline to be informed about what’s really going on in the economy. Join hundreds of thousands of readers, and get it free in your inbox every week.