• Eng Guan

The Tail Risk Behind Buy & Hold

Updated: Aug 1

Investing is simple. Just buy and hold an index fund for the long term.

You must have come across this piece of investment advice. Even Warren Buffett made the same comment before. Now, if you have no idea how you should invest, then this is one viable approach. A simple buy-and-hold on an index fund easily outperforms most retail investors who are trying to beat the market trading in and out. A large-scale study on retail traders in the Taiwanese stock market over a 15-year period uncovers an unsurprising truth. Most retail traders fail to beat the market. Almost 90% close their trading accounts after 4 years and loss is one of the key reasons [Source: Haas School of Business].


But, is it just that simple and risk-free? Does it mean that as long as you hold your positions over 20-30 years, you are in good hands because the market rises over the long term? That is what mainstream advice paints it to be. Now, if you are a seasoned investor, common sense and experience would have taught you this - there is NO FREE LUNCH.


Every investment comes with its price tag - RISK. However, many dismissed these risks as something unlikely to happen. That is a very dangerous attitude. Because what is improbable does not mean it is impossible. The market has a track record of throwing such improbable tail events our way. When it happens, the price is often far heavier than you expect. And this is what led accounts to blow up and even professional funds to collapse.


The Really Big Grizzly Bears


Most of us lived through better times. If you ask anyone how much they expect the stock market to fall in a bear market, I believe you will get a typical answer of between 40%-50%. This is, by any measure, already a huge amount especially if you have a large portion of your wealth locked in stocks. If it happens at an inopportune time, it is enough to significantly derail your plans. But, are you aware that there are actual crises that cause way more damage?


1929 US Great Depression


The crash that ushered in the US Great Depression in 1929 was one. The S&P 500 lost 86% of its value over 3 years. If you have a million dollars invested, you are left with $140,000. To put it in another perspective, it packs the punch of almost 3 continuous bear markets each causing a 50% drop one after another. And the recovery was painfully slow in part due to being interrupted by World War II. In the end, it took 25 years before S&P 500 reclaim back its former level.


S&P 500 During US Great Depression
S&P 500 During US Great Depression

Japan's Lost Decade


If the US Great Depression sounds too ancient to register any impact, then look to Japan's Lost Decade. Japan's stock market entered a prolonged and severe downturn in 1989 abruptly ending its phenomenal rise. And before it can recover, the Great Financial Crisis hits in 2008. It found its bottom only in 2009 after losing 82% of its value. But before you rejoice, it is not over yet. Because Nikkei 225 has yet to recover back to its peak in 1989 even today after more than 30 years.


Nikkei 225 During Lost Decades
Nikkei 225 During Lost Decades

How does 2000 Dot Com & 2008 Great Financial Crisis Compare


The magnitude and severity of these "super" crises dwarf what we have experienced since 2000. To get a clearer picture, let's compare it against the more recent bear markets - the 2000 Dot Com Crisis and the 2008 Great Financial Crisis.

Loss of Value During Major Crises
Loss of Value During Major Crises

Both the Dot Com and Great Financial Crisis saw the market plunging between 50-60%. The former took 7 years and the latter 5 years to recover. But the market barely recovered from the Dot Com episode in 2007 before the onset of the Great Financial Crisis in the same year. So if we take that into consideration, the market took a total of 13 years to pull itself firmly out of this massive hole. Even then, this is nothing compared to the Great Depression or the Lost Decade in terms of magnitude and duration.


When And How You Invest Matters


Whether we like it or not, we have no control over how the market unfolds in the future. We can only decide when and how we invest. And when is a good time to start? In the midst of a bull market? What if the bull market ends suddenly? Or should I wait for the bear market to arrive? But what if the market continues ramping up for the next 10 years instead?


As you can see there is no clear answer because we don't know what the future holds. That is why the common advice is to avoid timing the market, start early and invest for the long term. These are sensible advice but how you invest does matter as much in determining how future market developments affect your investments. A simple buy-and-hold strategy leaves you fully exposed to the impact of extreme events. Let's run through a scenario to illustrate what I mean.


30-year regular buy-and-hold investment plan in Nikkei 225 flops


It is the year 1989. Let's assume you are 30 years old and looking to retire with $1,000,000 when you hit 60. This gives us a decently long time horizon of 30 years. And to achieve your target, you decide to invest in Nikkei 225 through a regular investment program given that Nikkei had done really well then.


This is your plan. You will start with an initial investment of $50,000. And for the next 10 years, you will pump in another $1,000 every month. That makes the total invested capital $170,000. And after that, you sit back and patiently wait to harvest your returns.


To realize your objective, you assumed you can get an annual internal rate of return (IRR) of 7% from your investments which is not unreasonable. But unfortunately, we all know what happened to Nikkei after 1989. That is the start of the Lost Decade or maybe better to call it Lost Decades. So what do you think you will have at the end of 30 years?


Results of a Regular Buy-&-Hold Investment Plan on Nikkei 225
Results of a Regular Buy-&-Hold Investment Plan on Nikkei 225

The good news is you didn't lose your capital, that is if we don't adjust for inflation. But the bad news is you only made a measly $7,309 over the 30 years. That translates to a puny internal rate of return of 0.2% per year. That is one gigantic shortfall against your target of $1,000,000. At 60 years old then, you probably wouldn't be looking to extend your retirement by another 30 years. While I am using Nikkei here, this scenario could have happened to any market. And even if the chance is low, it's definitely not something we can afford to have happened without putting up any defenses.


Move Beyond Buy & Hold & Focus On Managing Risk


Don't get me wrong, the point so far is not to discourage anyone from long-term investing in stocks. Stocks are an indispensable asset class that every serious investor should own in their portfolio. But at the same time, we should not leave ourselves entirely at the mercy of the stock market. The real job of a professional investor is not making predictions and getting them right. Predictions or views don't matter a single bit as far as the market is concerned. It is about managing risks and uncertainty, knowing your portfolio and its risk rewards. How will your portfolio respond to different types of regimes? What are the risks? Where are my exposures? What returns can I expect? What loss will I encounter? Where are the tradeoffs?


Diversify Into Different Strategies For Stable Returns


While we cannot fully eliminate the risk, we can manage and mitigate it such that we don't end up in the scenario just painted. To do that, we rely on good old diversification. But it is not your run-of-the-mill type of diversification. At the simplest level, we diversify across securities which is what most retail investors do. At the next level, we can diversify across geographies. And there is more. We can also diversify across asset classes. And finally, across strategies. We have written a post on the impetus behind a multi-strategy approach before. You can read it here.


At the strategy level, you can imagine yourself as the Chief Investment Officer (CIO) managing a team of portfolio managers (PMs) each with different skillsets. Each PM has its own edge in extracting returns out of the market that can be uncorrelated with what others are doing. They all have their own individual strengths and weaknesses. When one is down, another may step up. And together as a team, they can weather through different market regimes more effectively than any individual. As an example, even if one of the PM is invested in Nikkei, another may have load up on bonds, or invest in other markets that offset the losses from Nikkei. That buys time for the PM who invested in Nikkei to size down and eventually cut the position to stem further losses.


Below shows the model performance of a multi-strategy portfolio that is diversified across different strategies, asset classes, and geographies. For comparison, I used the MSCI World index as a reference to represent the world stock market. All dividends are reinvested and performance measured in USD for an objective assessment.


Multi-Strategy Portfolio Vs MSCI World
Multi-Strategy Portfolio Vs MSCI World (Updated till June 2021. Performance measured in USD.)

With the right blend of strategies, even without any leverage, the multi-strategy portfolio outperforms the stock markets. And not just in terms of returns, it does so with much lower risk as well. The multi-strategy portfolio experienced only a maximum loss of -12% from 2006-2021. In contrast, a buy-and-hold on MSCI World underwent a loss of as much as -54% in the same period.


So invest wisely and be cognizant of the risks involved. To end off this post, let me also give a piece of advice from my own experience in the markets. Much of it was learned the hard way.


Be careful when you say it will never happen. Because if you are in the market long enough, you will see many "nevers" happen.

Note: We are working with iFAST Global Market to implement the multi-strategy portfolio for clients. If you are interested in knowing more. Please click here.

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