07/08/2014 06:01 pm ET Updated Sep 07, 2014

Why Buy-and-Hold Is Dangerous in Retirement

In a recent white paper, Investing for Retirement: The Defined Contribution Challenge, Ben Inker and Martin Tarlie show that asking the right questions can help investors reach the right solutions.

They argue against the conventional wisdom that retirees should invest according to their "investment personality," which is shorthand for seeking to maximize return within their tolerance for risk.  Instead, they argue that investors should be driven by their "needs and circumstances." In other words, they should invest according to their objectives and current market conditions.

If Inker and Tarlie have the right approach, the vast majority of financial advisers today are giving bad advice.

We happen to agree with Inker and Tarlie.  Many investors and advisers are operating under some bad assumptions.  They assume that all investors need to do is establish a risk tolerance and invest according to how much volatility they can withstand.  Unfortunately, they are leaving out an equally important variable: how markets are likely to perform over the investor's time horizon.

Most financial advisers ignore this important factor and simply assume that markets will provide returns similar to what they've provided in the past. They assume, "average returns."  The problem is, markets rarely produce average returns.  In fact, expected returns vary drastically over time!  And when valuations are high, as they are today, buy-and-hold investors are taking a big gamble.

Last week, we posted a video, How to Invest in a World of Low Expectations, which shows how much return expectations vary and suggests that a buy-and-hold portfolio may only produce real annual returns in the range of 2.3 percent over the next decade -- and come with plenty of unwanted volatility.

Find Opportunity Before You Jump In

In their paper, Inker and Martin demonstrate that tactical asset allocation (actively shifting your assets) may be better way to achieve your retirement goals.

It makes no sense to go to the grocery store if the shelves are empty. And it makes no sense to make big bets with your retirement assets when expected returns from stocks and bonds are near all-time lows. Matching your risk tolerance to your investments won't make a bit of difference if markets perform poorly.

Investment growth is determined by opportunity. And opportunities are provided by attractive valuations. Without opportunity, focusing on your risk tolerance ends up being pointless.

Today we see many passively managed portfolios with roughly the same allocations to stocks and bonds that they had when prices were depressed. You have to wonder if planners and investment advisors who recommend buy-and-hold investments, really understand that they're exposing their clients' retirement assets to markets with very limited upside.

Trees don't grow to the sky. What goes up, eventually comes down. There are times, (like these) when buying and holding stocks for the long-term simply doesn't pass the sniff test!

It appears that no matter how overvalued the stock market, some investors are going to just continue buying and holding stocks for the long term. The right question to ask: Is there a point where stocks and bonds are no longer reasonably and attractively priced?  Of course there is!

In the words of Inker and Tarlie, "We believe it is the height of folly to assume that a market trading at 45 times normalized earnings, as the S&P 500 was in 2000, can achieve similar returns to one trading at 7 times, as it was in 1982." When the only tool in your bag is buy-and-hold, then there is only one choice for every market. But we know, of course, that not all markets are created equal.

Why Valuations Matter

Stock valuations are mean-reverting, and as a result stock returns have a significant element of predictability. Inker and Martin write, "Valuations cannot tell us much about what returns will be over a week or a month or a quarter, but over a period of years the importance of valuation steadily increases. For example, valuations have had a roughly 60 percent correlation with future 10-year returns."

Today, stock market valuations measured by PE Ratios are in the 91th percentile. The stock market is anything but attractive in the long term. While that doesn't mean stocks have to go down tomorrow, it does increase the odds of a significant loss, and points to little or no gains over the next decade.  Buy-and-hold investors should pause and reconsider their investment approach.

Time to Quit Buy-and-Hope

When there are little or no long-term investment opportunities, a passive approach should be avoided completely.  No amount of risk is going to provide positive returns when the market is overvalued. No passive buy-and hold investment strategy is going to be able to overcome falling prices. To work effectively, passive investing has to be started at the right time -- when valuations are low. We believe this is a good time to move from passive buy-and-hold investing into an active, disciplined approach.

In today's market conditions, investors should be looking at shorter time frames. They should be shifting their portfolio in and out of markets based on which assets classes offer the best short- and intermediate-term opportunities.

Trend-following and relative strength indicators have worked well for over a century now.  Momentum investing isn't perfect, but it's not likely to fail any time soon. By owning assets when they are rising and avoiding them when they are falling, investors may be able to achieve better results than buy-and-hold. Most importantly, they are also more likely to perform better in the next bear market.

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