Thursday, September 16, 2010

Buy-And-Hold In The Age Of High Frequency

How valid is 'buy and hold' maxim today?


IS THERE really such a thing as a 'long-term' investor who buys stocks to hold them for years and years, riding out the inevitable volatility in the interim because he buys the conventional wisdom which says that over the long term, say 10 years or so, the returns from stocks will always be better than bonds?

For small investors, 'buy and hold' is getting to be an increasingly difficult strategy to justify in today's modern, computer-driven and volatile markets in which equities may be losing their original appeal.

Or is such a creature today nothing more than a romantic anachronism in a market where algorithmic or high-frequency trading (HFT) dominates everyday life and millions can be made in the blink of an eye?
For believers in the 'buy and hold' maxim, one of the more interesting broking reports released in the past fortnight was Citi Investment Research's 1 Sep Global Equity Strategist titled 'The End of a Cult'. Its thesis is that for Western investors, equities have lost a lot of their lustre over the past decade because of two debilitating bear markets (the dotcom bust of 2000 and the sub-prime scam of 2008) and this has resulted in large, disillusioned pension funds shifting their money into bonds.

Citi traced the start of the 'cult' of equities to the late 1950s, possibly because it was around this time that Harry Markowitz developed the idea of an 'efficient frontier' that led to the belief that a well-diversified portfolio could achieve superior returns while minimising risk and so laid the foundations for modern portfolio theory - and of course, the 'buy and hold' rule of thumb.

The broker also pointed out that the equity cult then benefited from a self-fulfilling prophecy - initial outperformance meant pension funds bought more and more stocks because they were outperforming and this in turn led to more outperformance.

However, although stocks lived up to expectations in the 1960s to the 1990s, since the end of 1999, Citi found that global equities have returned just 4 per cent in total.
On top of this weak showing, investors have had to cope with brutal volatility which has severely tested their patience (and undoubtedly, their nerve). The conclusion is that 'just as strong returns helped build the cult of the equity in the 1950s, so weak returns are tearing it down now'.

Local investors will probably find this has a familiar ring to it. Since 1998 they have had to endure not two large-scale bear markets but four - the 1997/98 Asian/Clob International crisis, the 2000 dot-com crash, the 2003 Sars/Gulf War and the 2008 sub-prime fiasco. In all cases, losses were at least 50 per cent (much more for the 1998 bear market).

Of related interest was a report that ran in a recent issue of International Economy magazine titled 'The Marginalising of the Individual Investor'. As the name implies, its authors, who were highly critical of HFT, argued that small investors will probably become more and more marginalised as HFT gains increasing importance in today's marketplace.

The report was also very critical of the means adopted by HFT players, implying that market manipulation could also be a worry as fundamentals are relegated to secondary importance.

Leaving aside a discussion of the pros and cons of HFT for now, the implication of all this as far as small investors are concerned has to be that 'buy and hold' is getting to be an increasingly difficult strategy to justify in today's modern, computer-driven and volatile markets in which equities may be losing their original appeal. How to adapt is of course the $64,000 question (as is the issue of how to regulate such trading) but maybe for now it's enough to recognise that the notions of an efficient market and investing for the long term have their appeal but both are probably nothing more than stylized ideals - just like the 'buy and hold' investor.

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