Investment Advice

The Ultimate Buy-and-Hold Strategyby Paul A. MerrimanPublisher and EditorI founded Merriman Capital Management in 1983. We had just finished an almost 20 year period that had led to huge market losses for most investors. In fact from 1966 to 1982, the S&P 500 had actually returned less than inflation. As we were not trying to be all things to all people we initially offered only market timing strategies to give investors an opportunity to participate in the equity market, but without the high risk of buying and holding.In 1992, as our firm decided to manage more of our clients’ money, we decided to seek a Buy-and-Hold strategy worth recommending to our clients. We found a strategy that is so good we decided to call it “The Ultimate Buy-and-Hold Strategy”. In this article I’ll explain why I think what we found is worthy of that name.We don’t use the word “ultimate” lightly. We would apply it only to something that’s the best we know. We think the term fits here. There’s no question that this strategy has worked very well. I think almost every buy-and-hold investor can use it either to increase returns or reduce risk – or both.The Ultimate Buy-and-Hold Strategy is suitable for do-it-yourself investors as well as those who want to hire professional money managers. It will work with small portfolios as well as large ones. It’s easy to understand and easy to apply using low-cost, tax-efficient no-load index funds.By the way, I want to make it clear that we did not invent this strategy. It evolved from the work of many people over a long period, including some winners and nominees of the Nobel Prize in economics.A “perfect” investment strategy would be cheap, easy to implement, would have no risk and would make you fabulously rich in about a week. Tax-free, of course. We haven’t found that combination, and we don’t expect to. But the Ultimate Buy-and-Hold Strategy comes as close as we have yet found.The Ultimate Buy-and-Hold Strategy produces higher returns than the investments most people make. It does so at lower risk, with minimal transaction costs. It’s mechanical, so it does not depend on finding the right guru to make the right predictions about an individual company, the market or the economy. You will never again have to rely on “The 10 Funds You Should Buy Now” articles in the popular financial publications.Even though this strategy is based on the finest academic research available, it’s simple enough that investors can understand it if they can grasp a handful of simple concepts.THIS STRATEGY IN A NUTSHELLIf I had to sum up this strategy in one sentence, I’d do it this way:The Ultimate Buy-and-Hold Strategy uses no-load index funds to create a sophisticated asset allocation model with worldwide diversification and the addition of value stocks and small-cap stocks to a traditional large-cap growth stock portfolio.If you think you already know what that means and you’re tempted to skip the rest of this article, I hope you’ll think twice. The evidence I’m about to show you is compelling, and I hope you’ll let me present it.If there is a “catch” to this strategy, it’s availability. You can’t buy it in a single mutual fund. You can put it together approximately using Vanguard’s low-cost index funds. But the “ultimate” way to implement the Ultimate Buy-and-Hold Strategy is to hire a money manager (including but certainly not limited to Merriman Capital Management) who has access to the institutional funds offered by Dimensional Fund Advisors. (More about those funds later.)WHAT REALLY MATTERSThis strategy is based on more than 50 years of research into the question: What really makes a difference to investment results? (Some of the answers may surprise you.) The people behind this research include Merton H. Miller, a 1990 Nobel laureate; Rex A. Sinquefield, who started the very first index mutual fund; Roger G. Ibbotson, a Yale finance professor whose market charts going back to 1926 are a fixture in the offices of most money managers; Kenneth R. French, a professor of finance at the MIT Sloan School of Management; and Eugene Fama, a professor of finance at the University of Chicago.Their expertise has been pooled in a company Rex Sinquefield started in 1981, Dimensional Fund Advisors, to give institutional investors a practical way to take advantage of their research. Today Dimensional Fund Advisors, or Dimensional, manages $50 billion of investments for major pension funds and large corporations as well as its mutual funds, available to individual investors through a select group of investment advisors.NOT FOR EVERYBODYBefore I get into the meat of this strategy, I want to issue a few warnings. The Ultimate Buy-and-Hold Strategy is not suitable for every investing need. It has had good returns on a long-term basis, but it won’t necessarily shine in any single week, month, quarter or year.Like most worthwhile ways to invest money, this strategy requires investors to make a commitment. If you are the kind of investor who dabbles in a strategy to check it out for a quarter or two, don’t even bother with the Ultimate Buy-and-Hold Strategy. You would simply be relying on luck for such short-term results.Often investors ask me questions like: “How did this do last year? How is it doing so far this year?” Or they tell me they think they (or I) should be in some particular type of asset over the next few months or the next year. These people aren’t likely to succeed with the Ultimate Buy-and-Hold Strategy because their focus is on the short term, not the long term.I want to make this crystal clear: The Ultimate Buy-and-Hold Strategy is not based on anything that happened last year or last quarter. It’s not based on anything that is expected to happen next quarter or next year. It makes absolutely no attempt to predict what investments will be “hot” in the near future. If that is what you want, you won’t find it here.But if you want superior long-term performance from a buy-and-hold approach, the Ultimate Buy-and-Hold Strategy is the best way I know of to get it.The most important building block of the Ultimate Buy-and-Hold Strategy is also the most startling to some investors: Your choice of asset classes has far more impact on your results than any other investment decision you can make. Let me say this another way, because it flies in the face of a lot of conventional wisdom. Your choice of the right kind of assets is far more important than exactly when you buy and sell those assets. And it’s much more important than security selection, your ability to pick the very “best” stocks, bonds or mutual funds.Here is the heart of the matter: An academic study of 91 large pension plans over 10 years found that it was possible to account for 94 percent of a plan’s returns just by knowing how the plan allocated its assets. Basic allocations are among bonds, stocks and cash. Within each one of those big classifications are various types of bonds, stocks and cash-like investment vehicles.The researchers found that security selection accounted for 4 percent of a pension fund’s results and that the timing of investments accounted for only 2 percent. Ironically, most investors seem to spend at least 90 percent of their time concentrating on security selection and timing, the things that together make only 6 percent of the difference.BASIC BUILDING BLOCKSSo how does an investor choose the right asset classes? I’m going to show you exactly how to do that, illustrating it in a series of pie charts. We’ll start with Portfolio 1, a very basic portfolio. Assume that the whole pie represents all the money you have invested. This one has only two slices, one for bonds (labeled the Lehman Govt./Corp. Index) and one for equities (labeled the Standard & Poor’s 500 Index).This portfolio’s 60/40 split between equities and bonds is the way pension funds, insurance companies and other large institutional investors traditionally allocate their assets. The equities provide growth while the bonds provide stability and income.We don’t believe 60 percent equity and 40 percent bonds is the right balance for all investors. Many young investors don’t need bonds at all in their portfolios. On the other hand, many older investors may want 70 percent of their portfolios in bonds. But the 60/40 ratio of Portfolio 1 is the industry standard, and that’s what we will use as a benchmark in this article.For 31 years, from January 1973 through December 2003, this portfolio produced a compound annual return of 10.5 percent. That’s not bad at all, especially considering this period included major bear markets. I believe many investors could achieve their long-term goals with that return.Therefore, a long-term return of 10.5 percent becomes the benchmark against which we will measure the Ultimate Buy-and-Hold Strategy. We’ll unveil this strategy in more pie charts, splitting the pie into thinner and thinner slices. Each slice will represent an important asset class that I believe you should own.Another measure we will use for comparison is standard deviation. This is a statistical way to measure risk; to understand the Ultimate Buy-and-Hold Strategy, you need to know that a lower standard deviation is better, indicating a portfolio that is more predictable and less volatile. (For a more detailed discussion of standard deviation, see Appendix 3) The standard deviation of Portfolio 1 was 12.3, so we’ll use that as the benchmark.Hundreds of thousands of investors would be better off with Portfolio 1 than they are with their current investments, which offer too little diversification and too much risk. If they did nothing more than adopt this simple mix of assets, which is easily duplicated using no-load index funds, these investors would be more likely to achieve their long-term investment goals than they are now.So it’s important to realize that we are starting from a relatively high standard. At this point we can say that to achieve anything worthy of being called the Ultimate Buy-and-Hold Strategy, we must find a way to improve on two figures: We want a portfolio that can be expected to produce a return higher than 10.5 percent, with a standard deviation lower than 12.3.You can jump ahead in this article to the section where we lay out exactly how to implement this strategy. But that’s a shortcut that might be counterproductive. Whether you are a do-it-yourself investor or a client of a money manager, you are much more likely to be successful with this strategy if you have a solid understanding of why each piece of it is important.Most of the Ultimate Buy-and-Hold Strategy is concerned with allocating the equity piece of the pie. That’s where most of our focus is in this article. But this is a good place to say a few things about bonds.Most people include bonds in a portfolio to provide stability, which can be measured by standard deviation, and to produce current income, which of course is part of a portfolio’s total return. The more bonds you include in a portfolio, the less growth you are likely to have – and the more stability you are likely to have.