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Which is Better, Buy-and-Hold or Market Timing?

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In politics, Republicans typically have an awful time saying nice things about Democrats, and vice versa. And when you’re rooting for a basketball team, the referees always seem to favor the other side. When it comes to investing, many buy-and-hold investors think market timers are grossly misguided, and at the same time many timers just can’t understand why buy-and-holders leave their portfolios exposed to potentially huge market risks.

I’m not going to settle that debate this month, any more than I could prove that chocolate or peppermint fudge is a better or worse flavor of ice cream than vanilla. But as the year winds down, this is a good time for all investors to re-examine their approach to investing. Some people are confirmed buy-and-holders. Others are market timers. Many use timing to manage some of their money and take a buy-and-hold approach with the rest.

A huge number of investors think they are buy-and-holders, but in fact they use a peculiar form of market timing that we have described before, the ICSIA or “I can’t stand it anymore” timing system. Though this is probably the most widely used timing system in the world, we don’t recommend it. It relies on emotional reactions to market fluctuations. After a long period of market gains, this system induces many of its followers to finally jump into the market, usually against their better judgment, when they can no longer stand to sit on the sidelines watching other people making what looks like “easy money.” When the market’s in decline, this irrational system prompts its followers to remain invested, even as they continue to lose money, until they cannot stand the losses any more – and then to bail out when prices are very depressed.

It’s interesting that almost everyone who practices this system would agree with the notion that an investor should “buy low, sell high.” Yet in effect the ICSIA system usually leads them to do the exact opposite. I’ll assume that you would never use that timing model. But I’ll bet you know people who do!

This article is for investors who choose more rational strategies and are committed to do their best to stick to them. As we will see, that is easier said than done. But it can be done, and what follows may help you significantly increase your chance of success.

WHY THIS IS COMING FROM US

We built our reputation as market timers, and we understand it as well as anybody in the business. But we also offer buy-and-hold approaches and advice, and that gives us a unique perspective and the ability to take an unbiased view that most advisors cannot. Very few advisors can offer both types of strategies, just as few political analysts or sports commentators can be truly objective. The reason: sports, politics and investing all involve the tug of conflicting emotions. And conflicting emotions just can’t occupy the same brain at the same time very well. It’s hard to be happy and sad simultaneously. It’s pretty hard to cheer when the market goes down (as you would if you were a short-seller of securities) and also cheer when you see it go up (which makes most investors happy).

Think of the pickle I’m in. Every day the stock market is open, our clients are either making or losing money. Quite often, some clients are making money and others are losing it, all on the same day. The best days (Line 1 in the following table) occur when the market is up and all our clients make money because we are fully invested. On other days (Line 2 in the table), the market is up and our buy-and-hold clients get the full benefit from the rise while our timing clients are partially on the sidelines and missing part of that opportunity to make money. Such days are tolerable for us, because those timing clients are participating in at least part of the advance.

But there are other days (Line 3 in the table below) when the market is up and all our timing models are on sell signals. That’s when it gets complicated. Our buy-and-hold clients make money. Many of our timing clients are in a neutral position, getting money-market returns. But other timing clients, those who use simulated short positions (such as the Rydex Ursa Fund) lose money. Those are tough days for us. It’s not any simpler on days when the market is down.

I’ve tried to sort it out in the table below. “Our signals” are those generated by our four U.S. equity timing models. The “aggressive strategies” column applies to timers who use real or simulated short sales when all four models are in a sell mode and who use real or simulated margin when three or more models are in a buy mode.

This discussion focuses on individual days. But the same patterns can be just as true when you look at a week, a month, a quarter or a year. It just gets much more complicated for timing clients because of the interim market swings and changes of buy and sell signals within a week, month, quarter or a year.

You can see why, if you ask me whether I want the market to go up or down, my response will depend on what strategy is being used to manage your portfolio. What I really want is not for the market to do some particular thing, but for investors to have the strategies that are right for them. And I want them to have the tools to stick with those strategies without getting thrown for a loop by their emotions. That’s what FundAdvice.com is about. And by the time you finish this article you’ll have the information you need in order to know whether you will be more comfortable as a buy-and-holder or as a timer. You’ll know the advantages and disadvantages of each approach and you’ll know what emotional challenges each presents. And you’ll have some important tips on how to be successful with whichever investment approach you take.

Before we take a detailed look at each approach, let’s make some general comments. Some people think timing is an aggressive, risky way to approach the market, darting in and out, always looking over your shoulder. They think buy-and-hold investing is relatively safe. Other people see the opposite: timing is safer because it lets investors actively try to preserve their capital in downturns, while buy-and-hold investors take more risk by leaving themselves exposed.

In fact, either approach can be aggressive and either can be conservative. When you’re buying and holding, you become more conservative or more aggressive by adjusting your balance of fixed-income and equities investments. The most aggressive buy-and-hold approach is 100 percent in equities; the most conservative is 100 percent in fixed-income. In market timing, your fixed-income/equities balance also makes your portfolio more conservative or more aggressive. In addition, you can be more aggressive by using your timing models for leveraged investing or short sales.

Of the investors I talk to, those who participated in the market from 1965 to 1982 seem to have a bias toward timing. Investors who know only the 1990s may find this hard to believe, but from 1965 to 1982, after inflation, the U.S. stock market as a whole just broke even. Almost everybody who entered as a buy-and-holder in the late 1960s took a bath by the mid-70s, and it took them until the early 80s to fully recover.

I entered the investment business as a broker in 1966, and over the next decade, I saw many people lose most of the money they had invested in the glamour stocks of the day. Just about any stock with a name tied to the electronics industry was perceived as a potential gold mine. (Could there be a parallel with Internet stocks today?) A lot of extremely aggressive mutual funds, known at the time as “go-go funds,” loaded up on such stocks, leaving their investors with big losses.

WHEN THE BULL BECOMES A BULLDOZER

That’s why investors from that era seem to appreciate market timing, with its insistence that investors can and should get out of the way when the bull turns into a bulldozer. But all this history and caution is lost on many of the investors whose only experience is in the bull market that started late in 1990. As far as they can see, all that’s necessary to make money in the market is to put your money in, sit tight and hope for at least a little bit of good luck to avoid bad choices of stocks or funds. To them, buy-and-hold makes perfect sense. It wouldn’t seem quite that obvious if they had been buy-and-holders of Japanese equities since 1989 or of gold since it peaked in 1980.

EMOTIONAL NEEDS

Statistically, you can make a pretty convincing case that the unit of return for unit of risk is approximately the same with timing as with buy-and-hold. Look at it this way: The way to reduce risk in a buy-and-hold portfolio is to invest part of your assets in fixed-income securities or cash. And the way timing reduces risk is to shift assets into cash. Notice any similarity? To use an oversimplified example, suppose you determine that the proper balance in a buy-and-hold portfolio is 70 percent equities and 30 percent fixed-income. So you always leave that 30 percent in fixed-income, no matter what the equities market is doing. In theory, you could accomplish approximately the same thing by using a timing system that on average had you 100 percent in cash about 30 percent of the time. In either case, your total exposure to the market is 70 percent – and your results may be roughly similar, depending on the specifics of your timing model and the market’s patterns of ups and downs.

The point here is not to quantify this – that can wait for another time – but to note that the numerical results of buy-and-hold and market timing can be similar. But the emotional results can be very different.

Some people achieve emotional security by being in synch with the crowd, experiencing what the majority of other people are experiencing. Popular culture is full of examples, from television shows to movies to fashion in clothing. For these people, buy-and-hold is going to be the more satisfying approach to investing. Market timing will drive these people nuts, because their results will always be different from those of the market as a whole.

Other people achieve emotional security by protecting what they have, making sure it isn’t taken away from them. To them, buy-and-hold looks very scary, because it requires just sitting back and passively “taking” whatever the market dishes out. For these people, timing will feel like a relatively “safe” approach to investing.

ABOUT MARKET TIMING

To make sure we understand what we’re discussing, let’s start by defining market timing as a systematic (not random or whimsical) commitment to make changes in types of investment assets whenever the system you are following indicates that one type will perform better than another for the immediate future. Most of the timing we do is from an asset class into cash and vice versa, such as switching between U.S. stocks and money market funds. But market timing can take many other forms. You could move from large-cap stocks to small-cap ones, from European bonds to Latin American bonds, from healthcare stocks to Internet stocks, from equities to bonds or from short-term bonds to long-term bonds.

One thing that makes market timing difficult for many investors is the necessity to be out of the market during some of the time it is going up. There’s no way to avoid that when you use timing, and it is an emotional drain.

ADVANTAGES OF MARKET TIMING

Timing has three main advantages:

Timing guarantees to cut your risk by reducing the total time you are invested in an asset class such as U.S. or international stocks. Many timing systems have been very effective in protecting against “the big ones,” the disasters like those we saw in 1969-70, 1973-74 and 1987. Many newcomers to investing may regard those past years as ancient history. But I firmly believe that another “big one” is likely to hit the stock market again during our lifetimes. Timing prepares you for that and gives you a way to avoid much of the damage. There’s no such protection in buy-and-hold investing except having a substantial part of your portfolio devoted to fixed-income investments. And that reduces returns while it reduces risks. Warren Buffet and Peter Lynch, two of the most renowned investors of our time, have both been quoted as saying people shouldn’t be in the stock market unless they are willing to lose 50 percent. Are you willing and able to take that sort of loss? If not, market timing can let you be in the market without passively accepting that risk.

Timing gives you at least the possibility to increase your long-term returns by avoiding the devastating losses of a bear market.

Timing gives you a tool with which to employ aggressive strategies that use leverage, short sales or products that simulate them such as the Champion MarketMultiple contracts and Rydex mutual funds. Without a timing mechanism, such strategies are much more risky.

DISADVANTAGES OF MARKET TIMING

You face the risk of enduring a period during which your timing model doesn’t do what it’s supposed to do. No matter how well you choose your timing model or models, there is absolutely no way to know for sure that any model that’s been successful in the past will be successful in the future. Every system responds well to certain types of market patterns but may fail to work in response to other patterns. For example, a timing model can be designed to be very adept at reacting to sudden, sharp swings and high market volatility. But that same model may completely miss a gradual change of the market trend. On the other hand, a model that’s good at detecting gradual changes may be overwhelmed by sharp volatility. This can be a source of great anxiety for investors, and it’s one of the main reasons that for equity funds, we use multiple timing models instead of only one.

If you’re a timer, sometimes it won’t seem like you get much respect. That’s one of the emotional hurdles that goes with the territory. The popular press has a strange view of market timing. Every day you’ll find articles advocating shifting your assets from one arena to another, for the precise reason that one type of asset is expected to outperform another in the foreseeable future. Recently one of the popular suggestions has been to shift assets from large-cap U.S. stocks to small-cap U.S. stocks. The articles and commentators may call this active asset allocation, tactical asset allocation or dynamic asset allocation. We call it market timing. By and large, the press looks down its nose at market timers as misguided folks who believe they can see into the future. And yet almost every popular financial magazine parades a series of articles on its covers with headlines like “Stocks that will excel in 1998″ and “The best funds to buy now.” Somehow they don’t regard that as trying to predict the future. When a buy-and-hold investor outperforms the market, he or she is likely seen as a competent stock picker. And many buy-and-holders who underperform are regarded as merely unlucky, or laudably committed to an asset type that is just enduring a bad period. But when a timer outperforms the market, he or she is likely to be regarded as temporarily lucky. And when a timer underperforms, he or she is likely to be seen as simply (and perhaps permanently) misguided.

For the majority of people, market timing simply won’t work. Not because the systems are flawed but because investors simply won’t follow the systems. Being a timer requires a level of resolve, discipline and commitment similar to what’s needed to lose weight or train for a marathon.

Mechanical timing of the sort that we do requires you to look at the market every business day and to identify and follow meaningful trends according to one or more disciplined models. This means facing up every day to the biggest risk in a diversified portfolio, the risk that the market may decline. I sometimes think of a market timer as like a pilot constantly looking at the instrument panel and taking responsibility for every potential risk to the aircraft, its crew and passengers. Ignoring market risk – and that’s what buy and hold investing calls for – is a little bit like ignoring the fuel gauges in an aircraft. This daily responsibility for the financial markets is a burden that most people do not want to add to their lives. We live in a society that encourages us to lighten our burdens, not add to them. And for most people, watching the markets every day is hardly the centerpiece of a satisfying life!

Every time you make a move you face uncertainty. You cannot know whether you are doing the right thing. When your system gives you a signal, will you follow it or second-guess it because you think it is obviously wrong? It’s only human nature to second-guess. But once you override a signal, you are trapped. How long do you continue following your own judgment instead of your timing model? When the market starts going in a direction that you didn’t expect, what do you do?

A DOUBLE BUMMER

During bull markets, timers underperform buy-and-hold investors. The exceptions are timers who use leverage, and that increases their risk. Probably half of all timing trades will wind up as one of two kinds of losses. There’s lost opportunity, which occurs when you’re on the sidelines while the market is advancing. (It’s a bummer for many investors who are in a hurry to make as much as they can NOW!) And there are losing trades, which occur when the market’s falling and you get out, but you sell assets for less than you paid for them. (That’s a bummer, too, and it’s a direct loss of money.) Neither of these things happen when you buy-and-hold. Both happen with timing. A double bummer!

You can have not only a losing trade, you can have multiple losing trades in a row. Market timing sometimes requires you to make a series of mistakes. You hope they will be small ones, but sometimes they pile up one after another. Any single timing model can generate three to five losing trades in a row. The losses may be small individually and cumulatively. But you may feel as if your investments are being nibbled to death. Timing virtually guarantees that you won’t buy at the bottom of a market and you won’t sell at the top. But timing can get you in at the top (exactly what you don’t want) and out at the bottom (ditto). You’ll often get back into a market when prices are higher than they were when you got out. These losing trades can seem like huge emotional issues when they are happening. But if you stick with a timing strategy long enough, they will become merely historical squiggles on a graph. Just don’t expect that change of perspective to happen overnight!

To be successful with timing, you must use it as a long-term strategy. Yet anything that takes your mind off the long term and makes you focus on the short term is a disadvantage. And market timing does force you to focus again and again on short-term results. Often you will not like what you see, and this will weaken your resolve to stick with your strategy. If you abandon your strategy or modify it based on recent short-term performance, then you have lost your discipline. And without discipline, you may become vulnerable to emotional forces that will lead you astray more than they will lead you in the right direction.

Market timing results can be misleading. At the Seattle Money Show in October, a fellow timer came up to me all excited about a particular model for timing sector funds. He told me this system produced a compound rate of return of 35 percent over the past decade with a worst-case drawdown of only 6 percent. I congratulated him, but then I asked if he thought these results mean anything about the way that timing system will perform in the future. He agreed with me that they don’t, but he said it was still a terrific selling point for this timing model. In fact, exceptional results from proprietary timing models simply cannot be independently verified. And you cannot know whether the system as it stands today is the same one that generated the past results. Timing models are frequently fine-tuned from time to time, and the current version will behave differently from the one that was in use during the past. That doesn’t mean it’s inferior or superior, only different. It’s also quite possible that over the past decade a market timer actually used 30 different systems on 30 different accounts, and this was the most successful one, so that’s the one he talks about. That is what many mutual fund families do when they start numerous private “incubator funds,” expecting that one of them will be very successful so it can be turned into a public fund with a favorable “track record” while the others are discarded. (This is sort of like buying 20 stocks at the start of a year, being lucky enough to have one of them double in value and then telling all your friends only about this one stock, to make yourself look like a genius. I know you would never do that. But are you sure about your friends?) Even then, there’s absolutely no way to know whether that one system or that one fund or that one stock will continue to outperform the others.

When you follow our advice and use multiple independent timing systems, you will never be able to say you are the very best. Your results will always be a composite of your systems. We use only one model for timing U.S. bonds, because bonds are much simpler to time than equities, and this model’s success has allowed us to be the nation’s top-rated bond timer for the past 10 years according to The Hulbert Financial Digest. But I can guarantee that we wouldn’t have that position if we used four bond timing models.

Sometimes you will lose money when the market is going up. This will be particularly painful in aggressive strategies such as those employed by Rydex mutual funds and Champion MarketMultiple contracts that simulate margin and short-selling to attempt to boost returns in bull markets and produce profits in bear markets. It’s one thing to suffer lost opportunity by sitting on the sidelines while the market is going up. At least with that strategy you’re preserving your capital. But when the market is going up and you are short, you are losing money, and you’re doing so when everybody else seems to be making it. That can be extremely hard to explain to yourself or anybody else.

ABOUT BUY-AND-HOLD INVESTING

In contrast to market timing, buy-and-hold investing is relatively simple, though not necessarily easy. Let’s start by defining buy-and-hold as a commitment to carefully select the appropriate balance of assets for your portfolio, to invest in those assets either all at once or systematically over time, such as with a dollar-cost-averaging plan, and to do this with the intention to hold those assets until either you need the money or your investment needs change.

This definition excludes some things commonly done by many people who consider themselves buy-and-holders. For instance, you are not really a buy-and-holder if you sell securities to “take some profits” or to “lock in your gains” when you think those gains might evaporate. When you do that, you are engaging in timing. That means you aren’t a true buy-and-hold investor, by our definition, if you bought Japanese funds in the 1980s, then bailed out of them when you saw them start to drop in the early 1990s.

The old Wall Street rule says you should cut your losses and let your profits run. This doesn’t fit into our definition of buy-and-hold. If you’re a buy-and-holder (with the exception of rebalancing your portfolio), you will let your profits run. But the moment you start cutting your losses by selling, you are no longer buying and holding. You’re engaging in timing.

A true buy-and-hold investor won’t have any compelling reasons to watch the financial news every day. Imagine you had a neighbor who ordered a new appraisal of his home every week because he had a connection that would give it to him free. Would you think that was strange behavior? I would! Now think of the parallel with investors. If you’re setting money aside from every paycheck into a 401(k) plan, do you gain any useful information by looking up the prices of your funds every day or every week or by watching the stock prices on CNBC every day? I doubt it! If your neighbor has no intention of selling his home any time soon, the weekly appraisals are irrelevant and serve no purpose. Likewise, watching the market like a hawk is strange behavior for a true buy-and-hold investor.

Buy-and-hold is as close as it gets to one-decision investing. You put your money in carefully chosen markets, then walk away. That single decision of how to allocate your assets becomes extremely important. And your timing is important, too, as I’ll show you.

I believe the people most likely to succeed as buy-and-hold investors are those who are averse to placing large bets on one or two asset classes. When you do the allocation properly, you avoid making a single large bet. Instead, you make a series of small investments, each carefully considered. You know some will work out better than others, and you count on the composite to balance your more successful positions against your less successful ones.

But here lies perhaps the biggest hurdle you will have to overcome as a buy-and-hold investor: requiring yourself to evaluate the whole pie instead of the individual pieces. In a diversified buy-and-hold portfolio, there will always be individual assets that will disappoint you. If you focus only on these and lose sight of the overall result, you will have to wrestle with the temptation to second-guess your carefully contrived strategy and to tinker with the pieces of your portfolio. You will be in danger of becoming a market timer while you think you are doing buy-and-hold.

ADVANTAGES OF BUY-AND-HOLD INVESTING

Buy-and-hold investing has four main advantages:

It’s easy to manage your investments once you’ve made them. You don’t have to analyze economics or the market outlook. You don’t need inside information, you don’t need to make predictions and you don’t have to be particularly savvy. And because you don’t have to do anything about your investments, it is not time-consuming. Without daily responsibility for watching the markets, you are free to go on vacation and enjoy life without worrying about what’s happening to your investments.

You don’t run the risk of second-guessing buy and sell decisions, because you rarely make them.

You’ll have greater tax efficiency for yourself during life and for your heirs after your death. In your lifetime, your securities trades will be infrequent, and you won’t incur additional tax liability for capital gains, except those from mutual fund distributions and periodic rebalancing. If you die before you use up your capital, you are likely to have large unrealized capital gains that will not be taxed because you can pass them to your heirs with a stepped-up basis.

You’ll be in synch with the mainstream, so you won’t have to make mistakes, and in the eyes of the industry, you won’t be wrong. Because you will rarely sell, you’ll rarely take a loss on your investments. Over time, the upward bias of the market and your asset allocation will likely overcome and outweigh any temporary losses.

DISADVANTAGES OF BUY-AND-HOLD-INVESTING

While this may seem like a nifty one-step solution to your investment needs, it’s not a picnic unless you are strong emotionally. Consider these disadvantages:

You can lose money. In fact you can lose a lot. A buy-and-hold strategy doesn’t eliminate risk, it just spreads it around into chunks of manageable size. Without any protection other than your asset allocation, you may be required to passively accept substantial losses without doing anything defensive. Even when you spread your equities over many asset classes, a worldwide economic slump could depress the prices of all classes of stocks. Remember Peter Lynch and Warren Buffet: If you aren’t prepared to lose 50 percent, you shouldn’t be in the stock market on a buy-and-hold basis. Sobering, isn’t it?

You can take too much risk and as a consequence lose more money than you are comfortable with. Most inexperienced investors do not accurately estimate how much risk they can or should tolerate. Many believe they can tolerate just about anything in their quest for maximum returns. By overestimating their risk tolerance and wishing to ignore possible losses, they allocate too much of their portfolios to equities and wind up with an insufficient buffer of fixed-income investments to protect them in a major market decline.

You can take too little risk and as a consequence fail to achieve the return you need because not enough of your money is in equities. This may give you added comfort, but it can cost you performance and reduce your return over the long haul.

You may have to take a loss at just the wrong time. You may unexpectedly need the money at or near a market bottom, forcing a sale of securities that later appreciate substantially. To insulate yourself, you may need an emergency fund that necessarily reduces the assets you have available for equities.

You can invest in the wrong things – and remain invested in them. If you’re investing part of each paycheck in a 401(k) plan, you may be putting most of your money into domestic stock funds. That seems to many people like the “obvious” right thing to do these days after the last few years of spectacular gains in the Standard & Poor’s 500 Index. But imagine that 10 years ago you were employed in Japan, where stocks were soaring and the economy seemed destined to be the world’s next powerhouse. Nobody would have had to tell you, a Japanese worker, that the right thing to do was to put most of your retirement savings into Japanese equities. Had you done that and stuck to a buy-and-hold strategy, you would now have losses of 50 percent or more. Nobody would blame you for wanting to cut those losses. But when would you start selling? How would you know your timing was right? Without some timing system, you wouldn’t have anything to fall back on except your emotional tolerance for losses. Chances are, you’d revert to the unproductive and emotionally devastating “I can’t stand it any more” school of market timing that we discussed on the first page of this newsletter.

Even if you make excellent asset allocation choices, the timing of your initial purchases will have a large effect over your lifetime. Even a few months one way or another can make a huge difference in your ultimate performance. The table below shows theoretical results of $100,000 initial investments made in the S&P 500 Index on each of two dates, January 1, 1997 and August 1, 1997. The calculations assume each investment earned 12 percent annually starting November 1, 1997, and each was held for 25 years after the initial investment. The only difference between Investor A and Investor B was the starting date (and what happened to the S&P 500 between each starting date and the end of October 1997). Because Investor A got the benefit of six profitable months (and only one losing month) immediately after the initial investment, he winds up 25 years later with $418,623 more than Investor B. The disparity is purely the result of chance in the initial timing. How do you reduce the risk of being the “Investor B” in this scenario? You can use dollar-cost-averaging over a period of three to 12 months. However, you will never know in advance if that will help you or hurt you. Had Investor A done that in the hypothetical case in the table, he would have given up much of his advantage over Investor B.

You will probably want to feel and act like a smart investor, one who does not let either hard-earned assets or obvious opportunities slip away. But that can make it extremely difficult at times to maintain your discipline as a buy-and-hold investor. And that may make it particularly difficult for you to do the periodic rebalancing necessary to keep your portfolio allocated properly. The reason: rebalancing forces you to sell your profitable assets and buy more of your unprofitable ones. That has the advantage of making you “buy low and sell high.” While this seems like a wonderful idea, in practice it requires you to lighten up on investments that are doing well (for instance by selling the Standard & Poor’s 500 Index) and load up on what’s lagging (for instance by buying Japanese-based equities). No matter how much faith you have in the long-term wisdom of rebalancing, I can almost guarantee there will be times when you won’t want to do it.

THE KEYS TO SUCCESSFUL INVESTING

If it was easy to be a successful investor, everybody would do it and we’d all be wealthy. But it’s not easy, and most investors don’t even come close to reaching their potential for building wealth.

Whether you choose buy-and-hold or market timing, you’ll be best served if you take a disciplined approach that calls for doing things that are contrary to human nature and just plain uncomfortable. One good way to deal with these hurdles is to hire an investment advisor to do the things that are uncomfortable but that must be done. This won’t spare you from the emotional stress that goes with either approach. But at least it will ensure that your strategy will be implemented. If you’re a do-it-yourselfer, I have no easy, magic answers for avoiding these difficulties.

Whichever approach you take, by yourself or by hiring somebody to do it for you, the three main factors that will determine your success are discipline, discipline and discipline. Here are some suggestions to improve your probability of success.

BEING A SUCCESSFUL BUY-AND-HOLD INVESTOR

Use broad diversification of assets to reduce your risk, especially in equities. The Standard & Poor’s 500 Index is the “hot” item right now. But over the past 27 years, it has performed the worst of the nine major asset classes that we use in our Ultimate Buy and Hold Strategy. (The other eight are large U.S. value stocks, small U.S. growth stocks, small U.S. value stocks, large international growth stocks, large international value stocks, small international growth stocks, small international value stocks and emerging markets stocks.) Some of these other asset classes have outperformed the Standard & Poor’s 500 Index by 4 to 7 percent annually, with less risk than that of the S&P 500. One of the best sources of this diversification is index funds that track these asset classes.

Invest in funds that have provided the highest consistent rates of return over a span of decades. In most cases, this will mean index funds instead of actively managed funds (see next item).

Invest where you get the most tax efficiency. This means index funds. John Bogle, chairman of The Vanguard Group, recently gave this example to a nationwide audience of professional advisors and money managers: If you had invested in an average-performing equity fund from 1981 through 1996, your annual return would have been 14.3 percent. After considering all taxes, your return would have dropped to 11.8 percent – a loss of 2.5 percentage points. But had your neighbor invested over the same period in the Standard & Poor’s 500 Index, your neighbor’s return would have been 16.7 percent, a return that fell to 15.1 percent after taxes, a drop of only 1.6 percentage points. After tax considerations, Bogle said, the S&P 500 outperformed 92 percent of equity funds during that 15-year period.

Invest where costs are lowest. This is likely to lead you to index funds as well.

Invest where you know exactly what type of asset you’ll be getting. This means buy index funds when you can. If the only way you can get an asset class that you need is through an actively managed fund, choose one that restricts the manager to the asset type you seek.

Carefully identify your risk tolerance, and make sure your portfolio includes enough fixed-income securities to stay within that tolerance. See “Fine Tuning Your Asset Allocation,” for a detailed discussion of that topic.

If you can, use the institutional index funds of Dimensional Fund Advisors, which are available only through registered investment advisors. They will let you build the most efficient portfolio of asset classes. Minimum accounts for these funds vary from advisor to advisor, from $50,000 up to $1 million. For a list of advisors who offer these funds, please call our office toll-free at (800) 423-4893. If you are unable to use DFA funds, your second-best source of low-cost index funds is Vanguard.

BEING A SUCCESSFUL MARKET TIMER

Use mechanical systems that can be tested over decades of market cycles. Don’t rely on predictions or intuition, either your own or those of the experts. Intuition is wonderful in many arenas of life. But it’s not reliable when applied to investments. And it certainly cannot be tested for past results.

Use multiple independent systems. No single timing model is perfect, and none is reliable enough to justify “betting the farm” on it.

Let each timing model govern some percentage of your portfolio. For example, if you use our four models for U.S. equity funds, move in and out of the market in 25 percent increments so that you’re 100 percent invested, 75 percent invested, 50 percent invested, 25 percent invested or 100 percent out of the market, depending on the status of the models.

Don’t forget diversification in asset classes just because you are using timing. Let your need for return and your tolerance for risk tailor a balance between U.S. and international investments and a balance between fixed-income and equity funds.

Make sure your timing discipline is actually implemented. Hire a manager or a friend if necessary. If you are a do-it-yourselfer and you second-guess a signal by not acting on it or if you go on vacation and miss a signal, you can quickly become out of synch with your discipline. Once that happens, you may have a devil of a time getting back on track.

Consider investing in a mutual fund that uses timing to manage its portfolio. This is a good option if you don’t want to do the work yourself or if you do not have enough money to meet the minimum account size of a manager. This option greatly reduces your paperwork and gives you an emotional buffer from the details of timing. When there’s a losing trade, you’ll simply notice the fund’s share price has gone down. Even though the financial impact might be identical, you may find it much easier to accept a lower share price in a mutual fund than a statement showing that an individual account with your name on it had a losing trade. Buying a fund with internal timing lets you buy once, like a buy-and-hold investor, and still get the benefits of market timing.

DRIVING WITH THE REAR-VIEW MIRROR

By this point, you may have chosen sides between buy-and-hold and market timing. You may think you know what you can count on from these two approaches. But in fact, you still don’t know anything about the future. In each case, the only guidance we have is history. But the only thing that matters is the future. Imagine trying to drive a car down the highway with the windshield blacked out and the only way you can see the road is through the rear-view mirror. Pretty uncomfortable? You bet!

That historical rear-view mirror tells us that a globally diversified buy-and-hold equities portfolio should give investors an honest shot at a 12 to 14 percent compound annual rate of return over the next 10 years or more. But an honest shot is not a guarantee. The next decade could be a wild ride or it could be placid. It could be profitable or it could be unprofitable. It could be productive or it could be so-so. Using only calendar years, since 1964 there have been 25 10-year periods (including 1988-1997). In nine of those periods, more than one-third of the time, the Standard & Poor’s 500 Index compounded at less than 7 percent annually. In one case, 1965-1974, the index grew at only 1.2 percent – and that’s before the effect of taxes and inflation. After inflation, that decade produced an overall loss of 31.9 percent. The lesson here is that buy-and-hold investing does not always work out, especially when it’s concentrated in one class of assets such as the S&P 500.

Our rear-view mirror tells us that market timing is no more predictable than buy-and-hold. Much more than with buy-and-hold, the results of timing depend on short-term market movements and the interaction between the market and whatever timing models you’re using. In a period when buy-and-hold produces a 12 percent return, one timing model could produce 6 percent, another 18 percent. And during a period when buy-and-hold loses 10 percent, timing could lose money or make money. You just never know in advance.

Those are the stark realities of having to rely on the rear-view mirror for your road information. And as much as we’d like to see what’s ahead, all we will ever be able to see is what’s already happened. In any given time frame, it’s almost guaranteed that one of these approaches will outperform the other. But it’s completely impossible to know in advance which one that will be. For many people, the answer is to use some of each.

SHOULD YOU DO BOTH?

Some investors manage part of their money with timing and part on a buy-and-hold basis. In many ways that makes sense. It’s another form of diversification that may serve investors well. Think back to Table 1, which shows who makes money on which days. If you’re a pure buy-and-holder, you’re happy on days when the market is up, unhappy when it’s down. It’s very simple. If you’re a timer, you’re happy on only two of the six kinds of days we defined, unhappy on two kinds of days and neutral on the other two.

Now look at that table again and imagine you were a buy-and-holder who had put half your money into timing. By doing that, on days when our signals are fully or partly out of the market, you have diluted some of your gain and diluted some of your pain. Overall, a combination like that should smooth your bumpy ride. But you’ll face all the emotional challenges of a timer plus all the emotional challenges of a buy-and-hold investor.

Successful investing isn’t easy, whether you time the market or buy and hold. Either way, you are taking a risk – actually a series of risks. If you allocate your assets properly, those risks will be carefully chosen, carefully coordinated and limited by diversification. If you do that and apply the necessary discipline over time, you are likely to be rewarded for taking those risks. In the end, that’s what successful investing is all about.

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Paul Merriman is founder and president of Merriman Capital Management in Seattle and editor and publisher of http://www.FundAdvice.com. He is the author of two books on investing and writes a weekly column on mutual funds for CBSMarketwatch.com.

Which is Better, Buy-and-Hold or Market Timing?
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