Buy & Hold vs. Risk Management: Who Wins?

27 January 2017  |  Adam French
Buy & Hold vs. Risk Management: Who Wins?
To manage risk or to buy & hold?
They are very different ways of managing your investments, but which produces the best results? We explore the merits of both strategies and explain why we have chosen to dynamically risk manage our portfolios. We believe that our portfolios work in all market environments, benefitting long-term risk-adjusted returns.

Buffett or Yale? Not an easy decision. Buffett remains an advocate of buy & hold but Yale university recently published a paper illustrating the success of risk management. Both strategies have been shown to work, but which works better? And how do you choose? Either way the investor needs discipline; the former to leave your money invested even as markets fall, the latter to monitor the risk in markets. We discuss the two strategies in greater detail.

What is Buy & Hold?

“Our favourite holding period is forever” said Warren Buffett in 1988. He has long preferred the strategy of buy & hold to active management. But can it work for everyone? Maybe risk management can add further value to this long-term game.

No one knows what the market will bring but we do know that historically, the general trend has been upwards. Buy & hold capitalises on this upward trend, but it only works if you have the discipline to stay invested. Not many investors have the nerves of steel required to stay invested during periods of financial downturns.

A successful buy & hold investor carefully chooses assets that they are prepared to hold onto for a long time. They do not sell to lock in gains or to cut losses. Instead they rebalance their portfolio every few months to return to the original asset allocation. That is the hard bit; it means selling your winners and buying your losers. Investors frequently struggle with this instinctively difficult process.

The required long-term time horizon can be challenging too. How many investors actually have enough time to buy & hold? A quick look at the S&P 500 shows that investors planning to buy & hold in 2000 would not have recouped their losses until 2013. Life plans can take unexpected turns and the buy & hold investor may need their money back at the wrong time.

There are certainly upsides though. It’s low maintenance as you don’t need to worry about watching the markets and given you stay invested, transaction costs are low. There is also some comfort in performance following a benchmark, you can’t blame yourself for poor returns; they are just the result of a broader market trend.

It’s the emotional control that makes it hard. Buffett is famously quoted as saying ‘Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.’ Investors may start out with all the right intentions but the reality of watching their portfolio decline may be more challenging than anticipated (read more about behavioral biases when investing in our article on how automation can help). The investor may crack and sell as markets fall, ie. at the worst possible time. To buy & hold successfully relies on time and emotional control.

What is Risk Management?

Benjamin Graham, a mentor of Warren Buffett, once said: “The essence of investment management is the management of risks, not the management of returns.” Managing risk certainly has its supporters. We wanted to explain how it works.

Historically, a lot of investors have watched prices from the sidelines waiting for a good time to buy. Typically, they buy as the market is going up (so buy expensively), motivated by the returns made by others over the last months or years, and then remain invested until the market declines. So they sell out when prices are low, in an attempt to cut their losses. They manage their portfolios by monitoring returns, not risk.

Yale School of Management recently published a paper titled ‘Volatility Managed Portfolios’ in support of managing portfolios on a risk basis. The idea is that by reducing exposure to asset classes when their volatility is unusually high, investors can still generate a better performance than a static buy & hold approach. When their volatility is low, investors move into asset classes that are typically considered to have higher risk and benefit from their long-term return prospects. This strategy is contrary to traditional investment management as it enables investors to limit their exposure to higher volatility during times of financial market crises but still earn a better return than if they held onto their original portfolio allocation. Successful risk management creates portfolios that work in all market environments.

There are two different types of risk that need managing; fundamental and short-term excess risk. Fundamental risk varies according to asset class and changes very little over time. Excess risk, or temporary risk fluctuations above or below the fundamental risk, behaves differently. Periods of positive excess risk are often driven by short-term uncertainty and typically go hand in hand with lower, sometimes negative returns, punishing investors instead of rewarding them for taking more risk. By making adjustments based on volatility – or even better, based on downside volatility – and keeping risk carefully controlled, risk-adjusted returns will be smoother and better. An investor is much less likely to be exposed to and punished for taking positive excess risk.

The downside is that investors will have to work hard to monitor and adjust their portfolios and transaction costs will add up, pulling down returns. It’s therefore a strategy that is almost impossible for retail investors to implement without professional help.

Which Actually Performs Better?

Buffett is one of the most successful investment managers in history. Buy & hold has generated impressive returns for his clients and he continues to endorse the strategy today. However, a risk-managed strategy has only recently emerged as a meaningful alternative, as we now have access to the data, the computational power and the mathematical models to execute it. And it has been proven to work better than buy & hold when it comes to generating returns.

The same Yale paper calculated the cumulative returns for a buy & hold strategy vs. what they called a ‘volatility timing’ strategy in market portfolios of several OECD countries from 1926 – 2015. As you can see from the chart below, the returns in the volatility-timed portfolio climbed significantly higher than those in the buy & hold portfolio from inception.

Yale Study (2016): Risk-based Strategies Are More Successful.

Performance comparison Buy & Hold vs. Risk-based Approach (logarithmic scale)

Performance comparison Buy & Hold vs. Risk-based Approach (logarithmic scale)
Source: Moreira, A., and Muir, T. (2016), Volatility Managed Portfolios. Working paper, February 2016, Yale School of Management.
Past performance or future projections are not indicative of future performance.

How Are Our Portfolios Managed?

We believe in risk management. We pick up tremors of volatility in the markets and then adjust our portfolios according to each client’s individual risk tolerance. This ensures that our clients do not exceed the level of risk that they are comfortable with in the long term, or that they end up in a portfolio that is too conservative and misses out on performance potential. We avoid that potentially punishing exposure to positive excess risk and therefore generate a better return for every unit of risk an investor is exposed to. We combine an active attitude to risk with passive financial instruments (passive ETFs) and adjust asset class weightings according to the defined risk category for each portfolio. We call this dynamic risk management and believe that it creates portfolios that work in all market environments. If you want to find out more, read our section on ‘Better Risk Management’.

In Conclusion

Buffett’s success alone proves that buy & hold does work. However, a potential buy & hold investor needs to ask themselves whether they have the luxury of a very long time horizon combined with the discipline required to stay invested. Not many have that combination. We believe that portfolios with active risk management, but based on passive, low-cost index funds (ETFs), are the best solution for our clients; the time horizon doesn’t need to be ‘forever’ and by keeping risk carefully controlled our portfolios work as hard as possible in every market environment to generate the returns our clients deserve for the risk they are willing to take.

Sources:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2659431
1988 Annual Report of Berkshire Hathaway

Risk Warning – With investment comes risk. The value of your investment can go down as well as up and you may get back less than you invest. Past performance or future projections are not indicative of future performance. We do not provide any investment, legal and/or tax advice. If this website contains information regarding capital markets, financial instruments and/or other topics relevant for investments of assets, the exclusive purpose of this information is to give general guidance on investment management services provided by members of our group. Please note our Risk Warning and the Website Terms.

 

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Adam French
CO-FOUNDER & DIRECTOR
Adam spent the last 8 years working in London in the financial services industry. As Executive Director of Commodities Trading at Goldman Sachs, he was responsible for the Commodities Structured Products franchise. Prior to this, he worked in Derivatives Trading where he was responsible for electronic trading for private clients in fixed income, currencies and commodities products. Adam studied Business Mathematics and Statistics at the London School of Economics.