If Only I Had Bought and Held....
If only. If I've heard those two words once, I’ve heard them a thousand times. If only I had bought position X instead of Y, I would have struck it rich. If only I would have bought and held on instead of sold. If only…. The examples are countless, but let’s follow through to the more common outcome.
Retail investors love to chase performance. They consistently buy high, and sell low. In every bull market, the gods of skill and luck rain down on some managers, and they manage to outperform their benchmark for the time frame given.
Take a look at the ETF ARKK as an example. In 2020, it was as if Cathy Wood’s glasses provided special insight into tomorrow’s prices. She could practically do no wrong! ARKK gained 152.5% for the year, making it the best performing fund in the mid-cap growth category, and it put her on tv, every magazine cover, and every retail trader's radar.
The mouth-watering return attracted investors like flies on... Well, you know. In fact, at one point, ARKK was collecting $1 billion PER WEEK! And who could blame the investors? Who doesn’t want to more than double their money inside of a year?
We don’t blame people for jumping into ARKK. Cathy has an impressive track record, and she hasn’t forgotten how to invest. But how did most investors do? Well, the answer, of course, depends on when their investment with ARK was made.
Those that had the foresight to invest in ARKK before Cathy was making headlines enjoyed a huge capital gain. On paper. Even today, the buy-and-hold group is sitting on an unrealized capital gain. But, the reality is, the majority of investors are sitting on a loss. How? Because traders are humans, and they chase past performance. Yet how well you do in the market depends on how expensive stocks are when you enter.
At the beginning of 2020, ARKK was relatively cheap. At least, relative to its valuation at the end of 2020. As the fund moved from cheap to expensive, buy-and-hold investors benefitted. But, traders really didn’t want ARKK until after it posted eye watering returns. Then, everybody wanted in.
Only after posting triple digit returns did ARKK's asset inflows take a skyward trajectory. That means that the majority of the capital in the fund was put to work at much higher prices. Those positions are currently underwater. The performance chasers who poured cash into ARKK at its height did not benefit at all from the prior year’s performance.
Keubiko, a widely followed analyst and market commentator, has publicly spent the last year tracking ARKK’s cumulative dollar return alongside its cumulative investment flows. As of his December 1 update, ARK innovation’s cumulative dollar return has fallen almost to zero. To see how, look at the chart below.
See where it says record inflows? That is where the money really poured into the fund. The fund had no choice but to invest the proceeds into stocks, regardless of the current valuation. And since the stocks in the fund were relatively expensive at the end of 2020, it is no great surprise that the fund underperformed in the following year.
Investing in the market indexes is no different. The market indexes oscillate between periods of undervaluation and overvaluation. Buying and holding makes sense when stocks are cheap. But when they are expensive, a buy-and-hold approach is also an expensive way to invest.
So, next time you think "if only", remember, NOBODY gets to purchase prior performance. It's extremely easy to pick funds that did well, but almost impossible to pick the funds that will do well in the future.
There will be periods of time where buy-and-hold investors can point to outperformance, and periods where active traders will outperform. Both styles have their merit. It just depends on the current market conditions. When stocks are historically expensive, an active trading style will often outperform the buy-and-hold approach. So, before you buy an index, and then promptly forget that you own it, first look at the valuation. Is it cheap to begin with? If so, you will likely do well long-term. But, if it's expensive to begin with, then it might be years before you make any money. Let's look at one more example of how this can work on the major market indexes.
In 1999, you could buy anything with a .com after the name and do well. Stocks were screaming higher and anyone wanting to get in the market would have no doubt about where to put their money. The Nasdaq was the place to be! But imagine if you wanted to play it safe and bought the entire Nasdaq index (via QQQ) at the turn of the century. What would your reward be for holding long-term? To see, let's look at the following decade. Certainly a decade is considered long-term, right? If you disagree, check your portfolio to see how many things you have held for a decade or more.
Now look at the chart below. See the return a decade later? Admittedly, we are choosing the bottom of the next correction for our measurement, but imagine how difficult it would be to have lost almost 80% of the capital that you invested in 1999! Most traders wouldn't, and shouldn't, sit through those kinds of losses. Now, let's look at the same investment, but use a different time frame. This time, the buy-and-hold investor entered the market when stocks are cheap. This time, they saw blood on the streets and realized the market was oversold in 2009. How did a buy-and-hold approach work for the following decade?
The following decade looked nothing like the previous one, why? Because starting valuations matter. In 2009, there were record outflows of capital fleeing the market, and who could blame them? All they had to do is look at the previous decade of performance to see that the Nasdaq was a lousy place to put your money. Historical performance would have suggested you were nuts to invest in something that lost almost 80% of its value during the previous decade.
So where are we today? Are stocks cheap or expensive? There are many ways to measure stock valuations, and by most measures, stocks are historically at record levels. We can see why by looking at the below chart.
Rather than get into various metrics that measure valuations, let's just simply look at a long-term chart. Does the current price end at the bottom right of the chart, (cheap), or the top right? As we can see at a glance, stocks have been rising since 2009. It is hard to say they are relatively cheap, since they have risen 15X off of their lows.
Just because stocks are expensive doesn't mean that they can't get more expensive, but to blindly buy, and then hold, for the long-term at current prices carries substantially more risk than buying the indexes near the market lows would have.
Of course, we understand that money needs a place to go. You can't sit in cash for a decade waiting for the next crash to come along, and then assume you are going to buy it all up when stocks hit the bottom. There has to be a balance in there somewhere, and knowing where the market stands in the big picture can help you find that.