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The Ultimate Buy and Hold Strategy 2014

By Paul Merriman and Rich Buck

To get the most benefit from this article and related podcast, please print The Graphs or have them available to view.

In this article, we’ll show how a series of simple but powerful concepts can potentially benefit patient, thoughtful investors. This 2014 revision updates our hypothetical examples with data through 2013. The information presented in this update is derived using hypothetical performance. Such data does not represent actual performance and, although we have done our best to present this information fairly, hypothetical performance can be misleading and should NOT be interpreted as an indication of actual performance. It is important to read and understand the additional disclosures on pages 10-11 of this update.

If you are a serious investor, this article could be one of the most important things you’ll ever read. I am going to show you the buy-and-hold strategy with rebalancing that’s very close, though not identical, to the way I manage the buy-and-hold part of my own portfolio, as well as that of The Merriman Financial Education Foundation.

I have been recommending the Ultimate Buy-and-Hold as a sample strategy since 1992, and I don’t use the word “ultimate” casually. This strategy is based on the research of many prominent academics over a long period, including winners of the Nobel Prize in Economic Sciences.

In my view, it’s the best I have found. As I will show you, compared to a benchmark portfolio comprised of 60% Standard & Poor’s 500 Index and 40% Barclay’s Government/Credit Bond Index, the Ultimate Buy-and-Hold Strategy has historically increased returns and reduced risk. I believe almost every long-term investor can use it to their advantage.

This is the best investment strategy we have found.

This strategy is suitable for do-it-yourself investors as well as those who use professional investment advisors. It works in small portfolios (as little as $1,000) and large portfolios. The Ultimate Buy-and-Hold Strategy doesn’t require you to pore over newsletters, pick stocks, find a guru or understand the economy. It’s easy to understand and easy to apply using exchange-traded funds (ETFs) and/or low-cost no-load mutual funds.

The strategy in a nutshell

Even though this strategy is based on academic research, it’s really fairly simple. If we had to describe it in one sentence, here’s what we’d say: The Ultimate Buy-and-Hold Strategy creates a sophisticated portfolio with worldwide stock diversification by adding value stocks, small company stocks and real estate funds 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, resist the temptation. We have some compelling evidence to show you. If you apply this strategy diligently, it could make a big difference in your future, and your family’s future.

Realize that you can’t buy all of the pieces of this strategy in a single ETF or mutual fund. You can put most of them together using Vanguard’s low-cost index funds, but Vanguard doesn’t offer everything you need.

In my view, the best way to implement this strategy is to hire a professional money manager who has access to the institutional asset-class funds offered by Dimensional Fund Advisors (DFA). We’ll talk more about that later.

It’s not for everybody.

Before we get into the meat of this strategy, there are a few things you should know. Every investment and every investment strategy involves risks, both short-term and long-term. That means investors can always lose money. The Ultimate Buy-and-Hold Strategy is not suitable for every investment need. It won’t necessarily do well every week, every month, every quarter or every year. As investors learned the hard way in 2007 and 2008, there will be times when this strategy loses money.

Like most worthwhile ways to invest, 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, this strategy probably isn’t for you. You may be disappointed, and you’ll be relying entirely on luck for such short-term results.

People often ask me how this strategy did last year or how it’s doing so far this year. Some people tell me they think investors should be in some particular kind of asset over the next few months or the next year. This kind of thinking is usually the result of something they have read or heard, but likely haven’t researched thoroughly. The Ultimate Buy-and-Hold Strategy is probably not the best option for these investors because they’re hoping to get results in the short term.

This strategy is designed to produce very long-term results without requiring much maintenance once the pieces are in place. If that’s what you want, keep reading.

It is based on more than 50 years of research. 

The Ultimate Buy-and-Hold Strategy is based on more than 50 years of research into a deceptively simple question: What really impacts investment results?

The people behind this research include Harry Markowitz, a 1990 Nobel laureate; Rex A. Sinquefield, who started the first index fund; and Eugene F. Fama, a 2013 Nobel laureate, and the Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business.

Their expertise is pooled in a company that Sinquefield and David Booth started in 1981 to give institutional investors a practical way to take advantage of their research. Today, that company, Dimensional Fund Advisors, manages more than $300 billion of investments for pension funds, large corporations and a family of mutual funds that is available to the public through a select group of investment advisors.

Here’s the answer they found: Your choice of asset classes has far more impact on your results than any other investment decision you make. We know this flies in the face of a lot of conventional wisdom and almost all the marketing hype on Wall Street. Many investors think success lies in buying and selling at exactly the right times, in finding the right gurus or managers, the right stocks or mutual funds. But being in the right place at the right time depends on luck, and luck can work against you just as much as for you. Your choice of the right assets is far more important than when you buy or sell those assets. And it’s much more important than finding the very “best” stocks, bonds or mutual funds.

A 1986 study by Brinson, Hood and Beebower, largely confirmed by a follow-up study five years later and often cited by investment managers, tracked the investments 0f 91 large pension funds from 1974 to 1983. The researchers concluded that more than 93% of the variation in returns could be attributed to the kinds of assets in the portfolio. Most of the remaining variation was due to stock picking and the timing of purchases and sales.

So how do you choose the right asset classes? We’ll show you in six steps, starting with Step One, a very basic investment mix that represents the returns of two major asset class indices. The modifications made in Steps Two through Six represent the returns of additional asset classes that have historically helped raise returns and reduce risk.

The returns cited throughout this article are not those of any particular investment firm, as they use some hypothetical date.  As many investors will likely work with an advisor to build this portfolio strategy I have an assumed 1% management fee, but the results do not reflect many of the other potential transaction costs, fees or expenses that investors must inevitably pay. 

Step One: Start with the basics

Assume the whole pie represents all the money you have invested. This version of the pie has only two slices, one for stocks (Standard & Poor’s 500 Index) and one for bonds (Barclay’s Government Credit Index).

Step One’s 60/40 split between stocks and bonds is the way that pension funds, insurance companies and other large institutional investors have traditionally allocated their assets. The stocks provide long-term growth while the bonds provide stability and income.

I’ll say up front that we don’t believe 60% stocks and 40% bonds is the right balance for all investors. Many young investors don’t need any bonds in their portfolios. And many older folks may want 70% or more of their portfolios in bonds. However, the 60/40 ratio of Step One is a good long-term investment mix. It’s an industry standard, and we’ll use it throughout this article to illustrate our points.

For 44 years, from January 1970 through December 2013, this portfolio would have produced a compound annual return of 8.8%. That’s not bad, especially considering this period included four major bear markets. We believe that long-term return should be more than enough to let most investors achieve their long-term goals.

Therefore, for this discussion I’ll use a long-term annual return of 8.8% as a benchmark against which to measure the strategy. You’ll see this strategy unfold in a series of pie charts as I split the pie into thinner and thinner slices by adding asset classes.

Remember that we must also look at risk. Adding return while increasing risk is certainly possible, but it’s not what I am after here. I want risk to remain the same – or ideally, to decline. Therefore, another measure I will use to gauge this strategy is standard deviation.

Ideally, we want risk to decline.

Standard deviation is a statistical way to measure risk. (If you want to under-
stand this statistically, there are plenty of resources online, like Investopedia, that will tell you how it’s defined and applied). For our purposes, what you need to know about standard deviation is that a lower number is better, indicating a portfolio that’s more predictable and less volatile. The standard deviation of Step One is 11.3%, so I will use that as the benchmark.

Historically, many investors would probably have been better off with Step One than they were with their actual portfolios, which may have included too little diversification and too much risk. If those investors did nothing more than adopt this simple mix of assets – which is easily duplicated using a couple of ETFs and/or no-load index funds – they would probably be more likely to achieve their long- term investment goals.

Because of that, and because it is used by pension plans and institutional investors who must get sufficient returns for the long term, Step One is a relatively high standard from which to start. Anything worthy of being called an “ultimate” strategy must beat Step One in two ways. It must be worthy of a reasonable expectation that it will produce a return higher than 8.8%, and at the same time have a standard deviation of about 11.3 or less.

Most of the Ultimate Buy-and-Hold Strategy is concerned with the 60% side of the pie devoted to equities. That’s where the main focus will be in this article. However, it’s very important to get the bond part of this strategy right.

Most people include bond funds in a portfolio to provide stability, which can be measured by standard deviation. Many investors also expect bond funds to produce income, which of course is part of any investor’s total return. The higher the percentage of bonds that make up a total portfolio, the more stability that portfolio is likely to have – and the less long-term growth it is likely to produce.

Step Two: Modify bonds

Whether your portfolio is heavy or light on bonds, what matters is the kind of bonds you own. In general, longer bond maturities go together with higher yields and higher volatility (higher standard deviation, in other words). However, as you extend maturities beyond intermediate-term bonds, the added volatility (risk) rises much faster than the additional return.

My recommended tax-deferred bond portfolio is exclusively in government bond funds. The bond portfolio in this article, is comprised of 50% intermediate-term funds, 30% short-term funds and 20% in TIPS funds for inflation protection. (TIPS funds invest in U.S. Treasury inflation-protected securities, which automatically adjust their values and interest payments to changes in the Consumer Price Index.)

It’s important to get the bond part of this strategy right.

Why do I exclude corporate bond funds? In a nutshell, corporate bond funds entail some risk of default – a risk that tends to increase at the very times we most want stability. I believe in taking calculated risks on the stock side of the portfolio and being very conservative on the bond side. U.S. Treasury and government securities have historically been very safe.

Making these changes completes Step Two.

From 1970 through 2013, this portfolio would have had an annualized return of 8.7% and a standard deviation of 10.9%. The modifications to the bond component give the portfolio more stability (less risk) with similar return. For more discussion about the difference between the two portfolios please join me on my Ultimate Buy and Hold Strategy podcast. [link to podcast].

The change from Step One is modest. But there’s much more to come as we tackle the 60% of the portfolio devoted to stocks.

Step Three: Add real estate investment trusts

Despite recent history, investors are familiar with the long-term attraction of owning real estate. When this asset class is owned through professionally managed real estate investment trusts, or REITs, it can reduce risk and increase return.

From 1972 through 2013, REITs compounded at 10.4%, producing almost the same return as the Standard & Poor’s 500 Index (which returned 10.5% over that same period). The reason these two equity asset classes go well together is they tend to zig and zag at different times. Again, there is more discussion regarding performance on the special podcast.

As you will see in Step Three, when REITs made up 20% of the stock part of this portfolio, the annual return would have risen slightly to 8.8% and the standard deviation (risk) would have declined to 10.4%.

At this point we have basically broken even with the reduction in bond risk and addition of REITS. This is not an exciting start, but the best is yet to come.

Step Four: Add small-cap stocks

The standard pension fund’s stock portfolio, shown in Steps One and Two, consists mostly of the stocks of the 500 largest U.S. companies. These include many familiar names like ExxonMobil, General Electric, Johnson & Johnson, Microsoft, Pfizer and Proctor & Gamble. Each of these was once a small company going through rapid growth that paid off in a big way for early investors. Microsoft was a classic case in the 1980s and 1990s.

Because small companies can grow much faster than large ones, a fundamental way to diversify a stock portfolio is to invest some of your money in stocks of small companies.

To accomplish this, the next step in building the Ultimate Buy-and-Hold Strategy is to add small-cap stocks to the stock part of the portfolio. To represent small-cap stocks, I used the returns of the Dimensional Fund Advisors U.S. Small Cap Fund, which invests in the smallest 10% of U.S. companies.

The result is Step Four, a pie that now has four slices and which from 1970 through 2013 would have produced an annualized return of 8.9%, with a standard deviation of 10.8%. With these three changes, the strategy has now added about $265,000 to the cumulative return.

Step Five: Add value stocks

The next step is to differentiate between growth stocks and value stocks. Typical growth investors look for companies with rising sales and profits, companies that either dominate their markets or seem to be on the brink of doing so. These companies are typical of those in the S&P 500 Index of Step One.

Value investors, on the other hand, look for companies that for one reason or another may be temporary bargains. They may be out of favor with big investors because of things like poor management, weak finances, new competition or problems with unions, government agencies and defective products. And sometimes they are out of favor due to little interest in their industry.

Value stocks are regarded as bargains that are expected to return to their supposedly “normal” levels when the market perceives their prospects more positively. Some well-known examples, taken from the largest holdings of the Vanguard Value Index Fund in January 2014, include Exxon Mobil, General Electric, Chevron, AT&T and JP Morgan Chase.

Historically, value stocks have outperformed growth stocks.

The Ultimate Buy-and-Hold Strategy uses a systematic approach to identify value companies. This approach starts by identifying the largest 50% of stocks traded on the New York Stock Exchange and then including all other public companies of similar size. These companies are then sorted by the ratio of their price per share to their book value per share. The top 30% of this list – which are the companies with the highest price-to-book ratios – are classified as large-cap growth companies. The bottom 30% are classified as large-cap value companies. The process is the same for small-cap stocks.

Although the most popular stocks are growth stocks, much research has shown that, while it may not happen in the future, unpopular (value) stocks have historically out-performed popular (growth) stocks. This has been true of large-cap stocks and small-cap stocks, and it’s true of international stocks as well. According to research from Dimensional Funds large cap growth stocks have underperformed large cap value by 1 to 2 percent over various long periods of time. Also, small cap growth stocks underperformed small cap value by 3 to 5 percent during the same periods.

Therefore, we create Step Five by adding slices of large-cap value and small-cap value so that the stock side of the portfolio is divided equally five ways.

This would have boosted the portfolio’s historic return to 9.9%, with a lower standard deviation as Step One. And notice how much this would have added to the 44-year cumulative return: over $2.4 million. That is more nine times the “added value” that came from Step Four.

To recap, we started with a standard industry portfolio mix, refined the bond portion and then added real estate, small and value stocks to the stock portion. The result is an increase of 13% in annualized return (and about 59% in cumulative return) at essentially the same level of risk.

There is one more important step in creating the Ultimate Buy-and-Hold Strategy.

Step Six: Go global

Step Six takes us beyond the borders of the United States to invest in international stocks. U.S. and international stocks both go up and down, but often they do so at different times and different speeds. Because of this, international stocks are diversifiers that can reduce volatility. However, U.S. and international stocks can decline at the same time, as we saw in 2008.

Like U.S. stocks, international stocks have a long-term upward bias. Yet when the shorter-term movements of U.S. and international stock markets offset each other, as they often do, the combination has a smoother long-term upward curve than either one by itself.

There are two major reasons that international stocks help diversify U.S. stocks. First, they trade and operate in different economic environments with different growth rates and monetary policies. Second, currency fluctuations affect their prices when translated into U.S. dollars.

The virtues of small-cap stocks and value stocks apply to international stocks, just as they do to U.S. stocks. Step Six slices the stock portion equally 10 ways, adding international large, international large value, international small, international small value and emerging markets.

Emerging markets stocks have outperformed the Standard & Poor’s 500 Index over long periods of time. They represent countries that are growing rapidly, and they have become an increasingly important part of the world’s total market capital.

As you can see, the annualized return of Step Six jumped to 10.5% and the standard deviation is 11.2%. Cumulatively over 44 years, this portfolio would have grown to more than $8.1 million, about twice as much as Step One.

This completes the basic makeup of the Ultimate Buy-and-Hold Strategy, which over this time period would have increased annualized return by 25% without really increasing volatility. This investment strategy is not complicated, and it’s based on solid research, although it uses hypothetical returns. It doesn’t require a guru. It doesn’t require investors to figure out the economic landscape or make predictions about the future.

With 2008 and early 2009 still relatively fresh in our minds, let’s think about risk. While the standard deviation of Step Six is about the same as that of Step One, we think the real risk was much lower for Step Six. Consider that Step One contained only about 500 stocks. Now consider all the stocks held by all the funds in Step Six.

At the end of December 2013, according to Dimensional Fund Advisors, the funds representing the equity asset classes in Step Six collectively owned the stocks of over 12,000 companies. Step Six entails ownership in many thousands of stocks, not just 500. To our way of thinking, that much diversification is very worthwhile in terms of peace of mind.

Putting this strategy to work

The trickiest part of the Ultimate Buy-and-Hold Strategy is getting the level of risk right for each investor. The most important asset-class decision an investor makes is how much to have in stocks and how much in bonds. In these illustrations, we use a 60/40 mix. That is an industry standard, and we believe that over a long period of time, many investors can use it to accomplish their goals at reasonable levels of risk.

But this may not be right for you. You’ll have to decide on your own asset allocation, based on your goals and risk tolerance. Better yet, speak with a financial advisor who can give you informed and unbiased advice.

Using this strategy in taxable accounts

This combination of asset classes works best in tax-sheltered accounts such as IRAs and company retirement plans. In taxable accounts, we recommend leaving out the REIT fund and dividing that portion of the portfolio equally among the other four U.S. stock classes. We say this because real estate funds produce much of their total return in the form of income dividends that do not qualify for the favorable tax treatment afforded to most other dividends.

Many investors implement this strategy in taxable accounts to supplement their employee retirement plans in order to capture asset classes not available in those plans. Investors who take this approach, which we favor, should hold REIT funds in their tax-sheltered accounts.

What’s wrong with this strategy?

Even though this is the best buy-and-hold strategy I know of for serious long-term investors, it isn’t flawless. Investment markets are not highly predictable, and this strategy might not work as well in the future as it did in the past. The stock side of this portfolio is over-weighted to value stocks. Yet it is quite possible that value stocks will underperform growth stocks over the next 5, 10, 15 or 20 years.

The portfolio also contains lots of small-cap stocks, but it’s possible that large-cap stocks will do better than small ones in the future. This portfolio contains more exposure to international stocks than many advisors recommend. International stocks could underperform U.S. stocks in the future, as they have in the recent past. Likewise, it’s possible that bond funds, which make up a minority of this portfolio, could do better than stocks in the future.

All this uncertainty is simply inevitable.

Still, I believe the Ultimate Buy-and-Hold Strategy deals very well with it. If you own this portfolio, you aren’t overly dependent on any particular asset class. No matter which ones are doing well, you will probably own them. I believe that this is the best an investor can do. And when you have done your best, it’s time to turn your attention to something else. A very good “something else” is to make sure you are living your life the way you want to.

Disclosure and Disclaimer

This document contains hypothetical results. The data is based on transactions that were not made. Instead, the trades were simulated, based on knowledge that was available only after the fact and thus with the benefit of hindsight. There are tremendous limitations inherent in the use of hypothetical results as portrayed here and you should not assume that your investments will perform similarly or that you will not lose money. Results do not include the impact of taxes, if any.

I believe in the concepts presented here and use hypothetical data to educate investors. It should not be construed as actual performance nor should you expect your portfolio performance to replicate our hypothetical results.

Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for an investor’s investment portfolio. Paul Merriman is not an investment advisor, attorney nor accountant, and no portion of this article or his website content should be interpreted as specific investment, legal, accounting or tax advice.

Furthermore, the prospective investor is solely responsible for determining whether any investment, security or strategy, or any other product or service, is appropriate or suitable for the investor, based on the prospective investor’s investment objectives and personal and financial situation. The investor should consult with an investment professional, or an attorney or tax professional regarding their specific investment, legal or tax situation. Historical performance results for investment indices and/or categories generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results.

Data sources

The following data sources were used. All performance data are total returns including interest and dividends. All index data subtracts the current expense ratio for the comparable fund. A 1.00% management fee is subtracted from all returns except for the S&P 500.

Stocks

Emerging Markets: Fama/French Emerging Markets Index 1/1989 – 4/1994, DFEMX 5/1994 – present.

Emerging Market Small Cap: DFA Emerging Markets Small Cap Index 1/1989 – 3/1998, DEMSX 4/1998 – present.

Emerging Market Value: DFA Emerging Markets Value Index 1/1989 – 4/1998, DFEVX 5/1998 – present.

International Large Cap: MSCI EAFE (net dividends) 1/1970 – 7/1991, DFALX 8/1991 – present.

International Large Cap Value: MSCI EAFE Value Index (net dividends) 1/1975 – 2/1994, DFIVX 3/1994 – present.

International Small Cap: DFA International Small Cap Index 1/1970 – 9/1996, DFISX 10/1996 – present.

International Small Value: DFA International Small CapValue Index 7/1981 – 12/1994, DISVX 1/1995 – present.

Large Cap: S&P 500 1/1970 – 12/1990, DFLCX 1/1991 – 9/199, DFUSX 10/1999 – present.

Large Value: DFA Large Value Index 1/1970 – 2/1993, DFLVX 3/1993 – present.

Small Cap: DFA US Small Cap Index 1/1970 – 3/1992, DFSTX 4/1992 – present.

Real Estate Investment Trusts: NAREIT 1/1972- 12/1977, Dow Jones US Select REIT Index: 1/1978 – 1/1993, DFREX 2/1993 – present.

S&P 500 S&P: 500 Index, provided by Standard & Poor’s Index Services Group, through DFA, 1970 – present.

Small Value: DFA U.S. Small Cap Value Index 1/1970 – 3/1993, DFSVX 4/1993 – present.

Bonds

TIPs: Barclays U.S. TIPS 3/1997 – 9/2006, DIPSX 10/2006 – present.

Intermediate Government Bonds Five Year Treasury notes 1/1970 – 12/1972, Barclay Government Bond Index January 1/1973 – 10/1990, DFIGX 11/1990 – present.

Short-Term Treasuries: BofA Merrill Lynch One Year Treasury Note 1/1970 – 6/1977, BofA Merrill Lynch 1-3 year 7/1977 – present.
Yearly rebalancing is used.

  Disclaimer