A straightforward buy-and-hold strategy could be a costly proposition under today’s market conditions. Investors should consider a comprehensive investment plan constructed within a core-satellite portfolio framework and based on planned re-balancing across assets.
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Stock price movements in the last two months have left many wondering whether a buy-and-hold strategy is the most optimal form of investing.
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Stock price movements in the last two months have left many wondering whether a buy-and-hold strategy is the most optimal form of investing.
This column, in the edition dated February 28, discussed a core-satellite approach to portfolio construction. We address the buy-and-hold strategy here within this core-satellite approach.
The core-satellite portfolio is constructed based on an investment plan. Such a plan contains five elements- an investment objective, entry price, money management rules such as stops to minimise downside risk, price objective and an investment horizon.
The core portfolio, with exposure to low-cost index funds, should be held till the investment horizon. Any rebalancing is based on the loss tolerance level for the investor.
The satellite portfolio should be actively managed based on a well-crafted tactical asset allocation policy.
On the other hand, a straight forward buy-and-hold approach, which is not tailored to an investment plan, may not work as well. Here are three reasons why:
Suppose the price objective (based on intrinsic value) of a stock is Rs 200.
The high level of noise (speculative) trading in the market means that the stock could trade anywhere between Rs 50 and Rs 500!
Price objective and exits
Buying it at Rs 100 and holding it for a price objective of Rs 200 may then be a costly proposition.
Buying it at Rs 100 and holding it for a price objective of Rs 200 may then be a costly proposition.
What if the asset first moves to Rs 50 and stays there for 6 months? Or what if the asset moves to Rs 175 and then declines to Rs 50 in one month?
The reason asset prices wander far-away from the estimated intrinsic value is because noise-trading leads to high volatility. Now, volatility varies based on time. Today’s volatility is dependent on yesterday’s volatility, which may be dependent on the day before.
And volatility tends to be bunched up across trading sessions. A period of low volatility suddenly changes to a period of high volatility and vice-versa.
A straightforward buy-and-hold strategy in a highly volatile phase may underperform a strategy that leans on planned rebalancing between assets.
Opportunity cost
If the investor in the above example where to doggedly hold the asset at Rs 50 for 6 months, she will lose the opportunity to generate optimal returns from other investment avenues that are available today, thanks to innovative financial engineering.
If the investor in the above example where to doggedly hold the asset at Rs 50 for 6 months, she will lose the opportunity to generate optimal returns from other investment avenues that are available today, thanks to innovative financial engineering.
Here is where fusion investing helps. Fusion investing optimally combines asset valuation models with technical analysis to reduce opportunity cost and enhance portfolio returns.
A buy-and-hold investor would simply take exposure in a stock because the current market price is lower than the estimated intrinsic value. An investor within core-satellite framework would not.
In the example mentioned earlier, the investor may buy the stock only at Rs 125 and not at Rs 100.
The additional Rs 25 per share is the price that the investor pays for trend confirmation, which lowers opportunity cost.
And remember, the money not invested in the stock is deployed in some other income-generating assets.
Buying a stock for dividend was the order of the day 10-15 years back. Then, assets traded not far away from their face-value.
Dividend Yield
So, dividend of 50 per cent on the face-value would translate into a yield of more than 7 per cent. Any profit from capital appreciation was a windfall-gain. Not any more. Asset prices trade several times their face value.
So, dividend of 50 per cent on the face-value would translate into a yield of more than 7 per cent. Any profit from capital appreciation was a windfall-gain. Not any more. Asset prices trade several times their face value.
Even a 100 per cent dividend would translate into a yield of less than one per cent. So, buy-and-hold strategy set-up for dividend yield is sub-optimal.
All investors have to look primarily at capital appreciation to enhance portfolio returns.
And that requires an investment plan. The core portfolio has a rebalancing plan, even if it has an investment horizon of 10 years! A buy-and-hold strategy does not have a defined investment horizon.
Neither does it have effective stops to minimize downside risk. Banking on a belief that equity will generate positive returns in the long run is a costly proposition.
Conclusion
There is a belief among several investors that a buy-and-hold strategy is optimal for exposure through mutual funds.
There is a belief among several investors that a buy-and-hold strategy is optimal for exposure through mutual funds.
That may not always be true. Even mutual fund investments suffer from the three reasons stated above. So, mutual fund investors need to have a rebalancing plan even if their investment horizon is long-term.
Otherwise, their capital will suffer large drawdown, as investors have now realised after the market crash in January.
It is, hence, optimal for investors to draw a comprehensive investment plan based on the core-satellite approach.
A naïve buy-and-hold strategy would only be the choice for investors who neither want to seek financial advice nor craft an investment plan on their own.
B. Venkatesh
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