Buy and Hold (Part 1)

I can get behind the argument that the average investor should index. Security selection is difficult and most don't want to spend the time to attempt to outperform the index. Time spent trying to outperform the index might be better spent doing other things (esp. based on the size of their holdings).

However, the decision to index or not index is one part of the equation. The investor chooses not only the securities to invest in, but the relative proportions of different asset classes, or holdings in different ETFs/Index funds. If you believe in buy and hold, you might keep your asset allocation constant over time, changing them only as your risk aversion increases as you age (to hold more bonds). Given the cyclical nature of our economic system, this strategy is incredibly misguided. Different asset classes perform different over different time periods, suggesting that an investor should change their allocation as economic conditions change. Put more emphasis on stocks when the economy is doing well and pare back when it slows.

The mutual fund industry is interested in selling Beta, but due to the cyclical nature of the economy, many investors sell their funds as the market falls. In effect, the mutual fund companies receive more volatile, cyclical earnings as their AUM flucuates. However, if they were to focus on products taking advantage of cycles rather than just offering Beta, they would see less liquidation as markets fail, and investors would be less likely to sell their funds. Earnings would be less cyclical. Further, I would argue that this focus could result in a much more successful fund manager than normal. If people view their products as safer, not only would they be more willing to hold their assets with that firm in the long-term, but they would also want to hold more assets with them.

One concern you could have is that if all funds were structured as broad asset allocation funds that take advantage of the cycle, economic cycles would moderate. While I think returns to the strategy would be competed away in such a situation, I think there are three criticisms to that argument. First, not all funds would want to manage funds in that way. At present, most people are happy believing buy and hold is the best way to manage money or they believe their own method is more succesful, it would hard to convince everyone. Second, not everyone would structure their funds the same way. Some would focus on economic data, some might focus on valuations, some on technicals and momentum, while others could use a combination. Not all of the signals would come at the same time. Finally, for that argument to be true, the lack of participation of major investors would be a sufficient condition to smooth the business cycle. Personally, I am of the view that economic cycles are the fault of the Federal Reserve and they appear in specific sectors due to primarily technological change but also government regulations. The strategies I will look at don't try to time these changes, but use momentum data to figure out when others think it has changed. So if everyone were following this strategy, surely the momentum data would no longer be viable, but I doubt everyone would follow it.

I plan on following this post up with two more posts detailing two strategies I have looked at. One is simple enough that anyone could implement, but the second is more complex.