The strategy of Buy & Hold Investing has a lot of followers (including me), and one of it’s touted benefits is that it is a simple way to invest. In the case of passive investors, it primarily involves picking and maintaining an asset allocation plan for the next 10-50 years of your life. No need to monitor stock prices or decipher financial statements. However, “simple” and “easy to execute” aren’t the same thing. For example, “spend less than you earn” is simple. “Always save for a rainy day” is simple. But how many people actually do this?

So why don’t I think it will be easy?
The picture above is the cover of the August 1979 issue of BusinessWeek magazine. In case you can’t make it out, the picture is of a stock certificate folded into a paper airplane that has crashed, surrounded by many other crumpled airplanes. (No Photoshop back then…)

The title of the cover story is “The death of equities: How inflation is destroying the stock market.” I haven’t been able to find the full text of the article noted, but I did find some snippets at TheFiendBear. He notes that the article “was published at a time when the Dow was languishing at 875 and had been trading in a see-saw fashion ever since topping out 6 1/2 years earlier in January of 1973. Inflation was a persistent nag on the economy and the Federal Reserve and US fiscal policies were held in low regard.”

Sound familiar? Now here are excerpts from the actual 1979 BusinessWeek article. Here is the summary:

The masses long ago switched from stocks to investments having higher yields and more protection from inflation. Now the pension funds–the market’s last hope–have won permission to quit stocks and bonds for real estate, futures, gold, and even diamonds. The death of equities looks like an almost permanent condition–reversable someday, but not soon.

Pension funds invested in diamonds? Wow. But stocks always beat bonds over long periods, right?

Until now, the flight of institutional money from the financial markets has been merely a trickle. But it could turn into a torrent if this year’s 60% increase in oil prices touches off a deep recession while pushing inflation sky-high. As it is, the nation’s financial markets and its capital flows have been grossly distorted by 13 years of inflation. Before inflation took hold in the late 1960s, the total return on stocks had averaged 9% a year for more than 40 years, while AAA bonds–infinitely safer–rarely paid more than 4%. Today the situation has reversed, with bonds yielding up to 11% and stocks averaging a return of less than 3% throughout the decade.

Still, I thought stocks were a great inflation hedge?

The one rule whose demise did the stock market in could be summed up thus: By buying stocks, investors could beat inflation. Stocks were a reasonable hedge when inflation was low. But they proved helpless against this awesome inflation of the past decade. “People no longer think of stocks as an inflation hedge, and based on experience, that’s a reasonable conclusion for them to have reached,” says Richard Cohn,an associate professor of finance at the University of Illinois. Indeed, since 1968, according to a study by Salomon of Salomon Bros., stocks have appreciated by a disappointing compound annual rate of 3.1%, while the consumer price index has surged by 6.5%. By contrast, gold grew by an incredible 19.4%, diamonds by 11.8%, and single-family housing by 9.6%.

This isn’t to bash BusinessWeek, they were certainly not alone. Of course, since 1979 the U.S. stock market has had an awesome run, and now we are back to many people putting 100% of their portfolios into equities. But I am pretty sure that some time within the next 20-40 years there will be a similar fearful atmosphere. Imagine bonds outperforming stocks by 8% per year, for 10 years. Imagine very smart people, pension funds, moving their money as well.

Imagine this article being written 40 years later (replace 1979 with 2019, late 1960s with late 2000s), after all these crazy Fed cuts, money injections, and high oil prices spike inflation. Just something to consider. Will you still be able to buy and hold? I’d like to envision myself being a pillar of steadiness in that storm. 😀

So how did everyone do in their March Madness pool? In the book Wise Investing Made Simple by Larry Swedroe, there is a great explanation of why stock-picking is very difficult which incorporates sports betting. I’ll try to briefly paraphrase the idea here.

Sports Betting Basics
Let’s stick with college basketball. Earlier this season, Duke played Cornell. If you were simply betting on who was to win beforehand, most people familiar with basketball would pick Duke. Duke has won national championships, has a top-ranked recruiting class, has a famous coach, has better record against stronger opponents.

But, nobody in Vegas or any sports book will take that bet. Instead, you have an adjustment called the point spread. In this case, the spread was 30 points. Now you have to either bet that Duke will beat Cornell by more or less than 30 points. This is much harder.

How was this 30 point spread determined? By the collective opinion of the other gamblers! It is a common misconception that you are betting against the casino. Nope, the point spread constantly moves so that half of all bettors are on either side of the spread. By the time the game is over, the casino doesn’t care who wins. The casinos simply take the bets, pay off the winners, and walk away with their commission. (You have to bet $11 to win $10.) Great deal, huh?

Because of this point spread and commissions, it is very difficult to make consistent money betting on sports. How many professional sports bettors do you know of? A historical study of NBA games showed that the average difference between point spreads and the actual differences in score was less than 1/4 of one point! The collective opinion of gamblers turns out to be very good.

In other words, with the handicap of the point spread, you could bet on Cornell every year and still come out the same as betting on Duke each year. (This year, Duke only won by 13.) When this is true, it is called an efficient market.

Picking Stocks
When people say “buy a company with a strong brand, a wide moat, and good growth prospects”, it is like saying one should just bet on Duke to win. It’s simply not that easy. There is a handicap, but instead of a point spread it is the price of the stock.

A good company will be priced at a premium. For example, people may love eBay, Apple, or Google and think it’s the best business company ever. But at the price you have to pay (the market price), you’re not betting that eBay will be successful, you’re betting if eBay will be more successful than the collective market participants think it will be based on all the information currently available. Again, the data shows that beating this collective prediction is very unlikely.

The argument over whether you can get better risk-adjusted returns from picking individual stocks will probably go on forever. Is it skill? Is it luck? Either way, it is important to know that very few people pull it off over the long term, and I think this analogy illustrates one major reason why. Next time you feel like stock picking, try beating the spread on 10 different sports events first. 🙂

Yesterday I was asked by a foreign news publication some questions about my reactions to the current financial problems in the US markets. As I wrote my responses, I thought to myself “this is so boring that there is no way that it will be published”. I have no juicy stories of hoarding gold, selling all my stocks, or fleeing to ultra-safe bonds. Instead, here are my Ambien-like responses:

What have you been doing to protect your assets since last summer (when sub-prime mess hit financial markets)?

Nothing, really. I keep the same general asset allocation and haven’t sold anything. I already have investments in inflation-protected bonds and broad stock index funds, so I am not worried about short-term losses.

To avoid investing losses, in trading, what kind of financial products (like stock/bonds/REIT and so on..) did you sell? and what did you buy instead? How did you change your asset allocation?

I did not change my asset allocation at all, as I still have a long-term investing horizon.

Have you changed your thoughts about investment under current crisis in financial markets?

No. I did consider adding some commodities for additional inflation protection, but I ultimately decided against it.

Have you been negatively or positively impacted by the current financial crisis?

Negatively, I suppose. Besides the drop in my investment portfolio, my house which I bought recently will probably decrease in value over the next year or two.

I usually don’t pay attention to short-term market moves, but I just can’t take my eyes off of this Bear Stearns train wreck! The recent timeline is almost amusing (assuming you don’t hold BSC shares…):

January 12th, 2007
Share price was $171.51.

March 10th, 2008 – Monday
Closed at $62.30 per share. From Bear Stearns CEO via Bloomberg:

“Bear Stearns’s balance sheet, liquidity and capital remain strong,” Chief Executive Officer Alan Schwartz said in the company’s statement. Alan Greenberg, the former Bear Stearns chief executive officer and current board member, told CNBC that the liquidity rumors were “totally ridiculous.”

March 11th, 2008 – Tuesday
From Jim Cramer via CNBC’s Mad Money:

Dear Jim: Should I be worried about Bear Stearns in terms of liquidity and get my money out of there? -Peter

Cramer says: “No! No! No! Bear Stearns is not in trouble. If anything, they’re more likely to be taken over. Don’t move your money from Bear.”

March 14th, 2008 – Friday
Closes at $30 per share. Federal Reserve gives emergency loan to Bear Stearns. CEO Schwartz clarifies earlier statement:

“Our liquidity position in the last 24 hours had significantly deteriorated. We took this important step to restore confidence in us in the marketplace, strengthen our liquidity and allow us to continue normal operations.”

March 16th, 2008 – Sunday
JP Morgan agrees to acquire Bear Stearns via a share exchange for the equivalent of $2 per share. The money for this is provided by the Federal Reserve Bank, which agreed to cover any potential losses if the loan defaults. Huh? How come I don’t get no-lose deals like this?

Now What?
Will this help contribute to a full 1% drop in the Fed Funds rate on Tuesday as is expected by the futures market? If so, it may be a good time to lock in some bank CD rates today. As for me, I’m going to have to re-read all those articles on why timing the market is bad. 😉

I received another reader e-mail whose question was very similar to this worried young investor’s question from back in November. Essentially they still wanted to know my opinion in this bleak market and if there is something they should do. I can’t blame them for asking. Although I was in the buy-and-hold camp, here’s the chart for the Vanguard 2050 Retirement Fund (VFIFX) from November 2007 until now:

In addition to my suggestions in that post, I also wanted to add that I can empathize with their situation. My very first Roth IRA was only partially funded with $1,000 because that’s all the money I could spare at the time. I then proceeded to buy shares of Janus Mercury, recommended by various publications and rated 5 out of 5 stars by Morningstar at the time. How could I lose? This was around 2001-2002. It tanked. Although I didn’t sell that year mainly because I didn’t know what else to buy, the next year I was certainly not interested in making any more IRA contributions!

Looking back, I would say starting out involves a good dose of luck. Let’s say 60% of new investors are up during their first year. For these lucky folks, they have a bit of “house money” to cushion any future losses. They have a positive vibe, and are more likely to keep their portfolios constant and make a habit of contributing regularly.

But what about the other theoretical 40% of new investors? They start losing money in their very first year. The media is now showing nonstop stories of foreclosures, rising inflation, weak dollars, poor job reports. Beginning investors are not used these drops. In their eyes, it took them months if not years to save up enough money in a nice, safe bank account before finally opening a Roth IRA. Then in a few months nearly $1,000 (20%) of it might have already disappeared! Worst case, they might be turned off from stocks for years. I’m no expert, so I can only reiterate the importance of time horizon when investing.

I’d like to hear how other people remember their very first year investing. Was it a good year for you? Bad? How did you react?