Newsletter – May / June 2009 – What does buy and hold truly mean?
What does buy and hold truly mean?
The March-April newsletter was closed out with a brief synopsis of a complex topic: Modern Portfolio Theory and specifically how it actually has faired over a long study based on the data. The mea culpa here is that the subject really needs more attention than a half page affords. After all, the “buy and hold” approach is the conventional investment methodology, the methodology used by most investors through their defined benefit pension plans, advisory relationships with large financial institutions and most mutual funds they hold.
To begin filling in the discussion on the topic, first, let’s define and understand the principles behind Modern Portfolio Theory (MPT), examine again in more detail how it has worked in the past, and last, examine why it may not be the best strategy for today’s investment climate.
Modern Portfolio Theory was a put forth by Harry Markowitz back in the mid 1950’s in the Journal of Finance. The theory addresses inherent investment risk through the diversification of a portfolio across sectors and or across asset classes. Any one security alone is risky. When you put several together you reduce the risk. If one security performs less than the average return expected of it, you have others to pull up the slack the theory goes. The graph shown to the right is a visualisation of risk vs. return expectations from a properly diversified portfolio, whether 100% bonds, a balanced mix or 100% stocks. Any point on the arc represents a portfolio of securities that has the risk and return in harmony, and any portfolio landing on the arc is described as “efficient”. For example, if you are a moderate investor your portfolio of securities should land on the arc somewhere around its midpoint. The medium return/medium risk arrow implies that an investor has assumed the appropriate risk (lower axis) and accordingly, should be able to receive the appropriate return (vertical access) for assuming such risk. Any mix for the same investor that falls below the actual arc reveals that they have assumed too much risk compared to the reward potential, and hence, the portfolio would be deemed inefficient. No portfolio can be placed above the arc as it is an impossible scenario. The arc can be used to measure this relationship amongst or within any one class of investment as well. There are efficient all-stock or all bond portfolios. For example, if an investor only wanted to invest in equities, the lower end of the arc would be where utilities, pipelines or prosaic staples like Proctor and Gamble, would lie; small cap, emerging industries or emerging market securities would fall on the arc at the far right.
