Does the 'Buy and hold' strategy really work amid the current high volatility in equity markets?

Presented by- Akash Narayan Shetty Master of management studies (Mumbai University) S.I.E.S College of management studies

For Crisis young thought leader 2012

October 2012

FLOW OF REPORT Sir no 1 2 3 4 5 6 7 Topic EXCUTIVE SUMMARY INTRODUCTION ORIGINATION OF BUY AND HOLD STATERGY APPLICATION OF BUY AND HOLD STRATERGY UNDERSTAING BEAHAVIOUR OF EQUITY MARKET IN LONG RUN CONCLUSION BIBLIOGRAPHY Page no 3 3 4 4 7 10 10

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EXCUTIVE SUMMARY In 1969 if someone had invested $100,000 in George Soros set up quantum fund, his investment (presuming that dividend were reinvested) would have grown to $130 million by the spring of 1994 a compound growth rate of 35 % over a period of 25 years. Even if anyone invests in a basket of blue-chip Company and holds it for 30 years hes bound to be billionaire, right? Not in Japan. Nikkei is at same level as it was trailing in 1982; there would be no difference in value of investment in this 30 year period if anyone would have invested there. The Japanese market is not alone who demonstrated this trend. Stock indices of the European markets are down to 14-15 year lows. But investment in market like US and India are performing better with benchmark indices of their 2007 levels. With zero gain or even negative gain (considering inflation) after long period of investment, the strongly held strategy of long-term investment looks like dying. But financial expert and leader dont get tire of preaching that holding stocks for the long period of time will make u rich. We will try to understand this buy and hold long term strategy in this report examine its foundations, its benefits and long term investment during boon and financial crises. We will also discuss some wrong perception of investor in 21st century and try to correct it with finding. This report in divided into two phases, in first phase we will discuss about how buy and hold long-term investment strategy is applied. Then will move on to general misconception of present investors unveiling various trend related to buy and hold strategy. We have considered S&P 500 index for most of our analysis and US investment market since it have long history and more relevance in buy and hold strategy. INTRODUCTION Investment firm usually attract investor with concept of long term investment which guarantees high returns but there long term is not defined. The Indian stock market (NSE) have not generated any return in last five year, but if we see developed market like French, Germany, British, Spanish and Italy they will show worst performance as they are in same position as 13-15 year ago. US DOW Jones is still little above its level in 2007. If fund manager are not getting there desired result in 2-3 year for there client, time horizon is extended to five year, or even future to 8-10 years. So should we conclude that investor have to desert equities and focus their investments in the low deviating return giving assets like debt, gold and immoveable property? Well certainly not. Index chart will not show flat line for Indian and most other market as there was bullish phases and bearish phases. Accumulating profits periodically is perhaps the sole way to make serious money from this volatile stock market and in this report we will cover this concept relevance in todays market.

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ORIGINATION OF BUY AND HOLD STATERGY This strategy came into existence by more than 50 years of academic research, where they tried to find critical factor in investment return. Nobel Prize winners in economic science like Harry Markowitz, a 1990 Nobel laureate; Eugene F. Fama, Robert R. McCormick, Brinson, Hood and Beebower, and Rex A. singuefield are people who poured light on this topic. The top gear Buy-and-hold strategy will not ask u to read 2-3 business newspaper a day, glue to news channel, follow investment Guru or keep sharpening your economics. Here we create one sophisticate well diversified portfolio by adding undervalued stocks, small company stock, and bullion to a traditional large-cap stock and hold it for long period of time raging from 5 to 30 years (long-term is not defined). But we have to understand here that this strategy is not for every one. It requires undisputed commitment from investor who should not try to reevaluate his portfolio every month or quarter due to sudden change in market. So here investor are not manic to not react to unwanted happening in last quarter or next quarter or next year, but he had formed his portfolio after selecting stock with fundamentally strong growth prospect in long term. APPLICATION OF BUY AND HOLD STRATERGY So how do buy and hold strategy really work? Does it really give high return in stock with same amount of risk as bond? To answer this let us try to construct one portfolio considering investor of US, investing during 1970s and try to find real effect of ultimate buy and hold strategy on investment value in 2011. A- BASIC PORTFOLIO FOR BUY AND HOLD. Assume that this investor have invested his money in two assets, 60 percent in stock (standard and poors 500 Index) and remaining 40 percent in government bonds.

PORTFOLIO
S&P 500 40% 60% GOV BOND

BASIC PORTFOLIO ( January 1970 to December 2011) Return Basic 8.4% $100,00 will grow to $ 297,213 Table-1 Standard deviation 12%

Figure-1

Now here stock will take care of long term growth while the bond will consider stability and regular income aspect for investor. But this will not be optimum portfolio especially for young investor who will not like to include bond in his portfolio. But this is industry standard so we will use it throughout this report to convey our point. Now for 42 years, this portfolio will give compounding annual return of 8.4 percent and have standard deviation of 12%. So we can say any other portfolio which will give higher return with same or lower standard deviation would be better option to adopt. Even though bond is important part of portfolio management since its deviation increase with increase in term but our point of attention is 60 percent
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investment in stock, so let us look can investor increase his return by different buy and hold strategy in stock market.

B- EFFECT OF SMALL CAP COMPANY IN PORTFOLIO FOR LONG TERM. Now if investor is not satisfy with give 8.4% return he will look for better investment opportunity with same risk. We will try to reevaluate our basic portfolio by adding investment in real estate to give it realistic picture. Real estate investment trust, or REITs, will decrease risk and increase return since it has 10.8% compounded return. In our basic portfolio our stock allocation was in 500 largest U.S companies this will include company like P&G, Microsoft, Pfizer and general electric. Now this was not billion Dollar company since inception, like Microsoft which is classic case of rate appreciation of share price. When investor is able to find such companies which can grow at much faster rate compare to large business, he can diversify his stock portfolio by allocating portion in it. Using performance of U.S Micro cap fund of Dimensional fund (which invest in bottom 6%-7% companies) as proxy we can calculate new portfolio return and risk represented in below chart

PORTFOLIO
12% 12% 36% 40% GOV BOND US small cap S&P 500

BASIC PORTFOLIO ( January 1970 to December 2011) Return Standard deviation Basic 8.4% 11.8% Adding real estate 8.7% 10.6% Adding small cap 9.0% 10.9% $10,000 will grow to $368,636 Difference of first portfolio final value from present portfolio final value is $71,423 Table-2

Figure-2

With allocation only 12% in small cap we are getting appreciation in final value of $71,423, increase of nearly 24% and getting return of 9% over 8.4%. Risk had also reduced to 10.9% since chance of loss is just 12% of allocation but prospect for growth is very huge. But important point to note here is that if investor is ready to take higher risk and invest fully in growing small cap the difference of return would have been seven time the entire investment of $10,000. C- IMPACT OF VALUE STOCK IN BUY AND HOLD PORTFOLIO. Companies with rising turnover, profits, market leaders, or in process of becoming one are known as growth stock. Such companies are included in our basic portfolio S&P 500 stocks. We know that as value of company increases the chances of getting higher return in long term reduces so why should investor invest in such large company? Answer for this would be value stock. When stock of large company which is out of favor due to some unsystematic risk, but they have potential to return in normal level, are called value stock. Here investor will use
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price/book ratio and try to find bottom 30% large-cap values company. Lot of research has been done on this approach and important finding is that, out-of-favor value stock have majority of time out performed popular growth stocks. BASIC PORTFOLIO ( January 1970 to December 2011) Return Standard deviation Basic 8.4% 11.8% Adding real estate 8.7% 10.6% Adding small cap 9.0% 10.9% Adding value stock 9.8% 11.7% $10,000 will grow to $507,891 Difference of first portfolio final value from present I portfolio final value is $210,678 Table-3 If we take U.S large cap value Index and U.S small cap value Index of DFA U.S as proxy portfolio return will boost to 9.8% and standard deviation is also little less that first portfolio. With this we can see what extraordinary performance buy and hold stocks show. If used wisely growth of $210,678, more than 200% of basic portfolio final value. We have not included investment in international market due to constraint presentation.

PORTFOLIO
S&P 500 GOV BOND US small cap 40% 12% 12% US large value US small value REITs

12% 12%

12%

Figure- 3 With this we can say that how "Buy and hold" strategy was effective in this fluctuating equity markets till date and helped investor to get higher return. But is this strategy relevant today? Can we use this in present market where economic cycle has changed to 2-3 years from 7-8 years? Where tenure of company CEOs have reduced, 100 of products are launched every day, company are cannibalizing there own products. We can not predict future but we can try to understand history and answer some question which are been raised about buy and hold strategy in stock market in following part of report.

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UNDERSTAING BEAHAVIOUR OF EQUITY MARKET IN LONG RUN Now taking about general retail investor and portfolio manager whose biggest source of anxiety is market volatility. Learning the economic of equity market related to volatility can be stepping stone in the prudent management of our portfolio using buy and hold strategy. It would be unwise to say that when our equity portfolio has fallen by 10% or more stay invested and do nothing. We can say its risky if we compare to supposedly risk free investment for example long-term government bonds or money market funds. But if we try to study one of the richest investor Warren Buffet and other successful investor they avoid temptation to adjust their portfolio in response to short term dip in market. We will try to unveil some of most debatable point in market and try to get excess return by going against the tide being wise investor. 1- Volatility of equity returns in todays time is more than 25 or 30 year ago. Finding- Now we cannot deny the fact that there was upswing in volatility, which can be measured by price movement. If we track S&P 500 Index movement up or down by 1% or more we will get 136 such days in 2008- at the peak of the financial crisis. When tracked movement of same in 2006 just two years earlier it was 30 days. But if we remove past 30 year record for same index we get following finding as shown in below figure This cyclicality is part of a long term pattern as shown in this chart of daily volatility (measures in base point) have fluctuated repeatedly in cycles over the past 30 years. This sharp daily movement which will never settle does not tell full story. We are though in our investment class to measure risk using standard deviation () of return. By using this measure we will find that value of equity market have change but market risk has not increased remarkably over the past 35 to 40 years. If we consider last full decade which include worst stock market events like Internet bubble and Figure-4 The great recession, the standard deviation of equity market return for largest stock market US was 18.7% which is little more volatile than 17.6% found in the decade ending of 1990 and 17.2% in earlier decade ending.

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2- When price of stock rise or investor gain profit due to bullish period, portfolio theory (law of averages) says chance of getting high return in future reduces. Finding- If we consider market return in late 1990 or by 2007 or even during mid-2000 it was very high when benchmark was past returns. But we should not be misguided that our future return would be below average in the future since it was above average in past years. 3- Investor who pump money in stock market when market start to rise, otherwise stay in cash are smart investors. Finding- Even well trained or experiences professional investors cannot perform consistently art of timing the market exactly. So when this investor are out of market for even 30 40 days cost can be enormous. As we can see in below chart which show return calculated for more than 7000 Trading days. Now if investor misses 50 days which recorded biggest positive movement he would have also lost 98% of the total return during that period. Which also lead to reduction of total return from 8.4% P.A to only 0.2% P.A. same way investor missing 10, 20, 30 or 40 days which noticed biggest up days would have bear different amount of cost.

Figure-5 4- Considering the high risk in short term the long-term return paid by stock which is even though higher than bonds or treasury bills is not that justifiable. This extra return in stock is also due to some boom period in stock market which probability is also not consistent. Finding- When we see 84 year of historic return in stock market it have clearly beaten cash and bond with huge difference, rewarding the high risk. If we consider our investment in large capitalization US stocks at start of 1926, that portfolio value would have been grown to 3 lakh percent of the beginning value. Now if we replace this portfolio investment by long term government debt it would have grown to 9,200 percent, while if we consider investment in Treasury bill it would have grown to only 2,000 percent. Now considering such high return for equity market its volatile was also recorded higher than bonds or treasure bills, but 72 percent of time this volatility was positive in 84 years as

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shown in below figure. Only 12 percent of time investor had to burn there hands by loss greater than 10 percent and 7 percent of time loss more than 20 percent. When we talk about return more

Figure-6 Than 10 percent, an occurrence of it was 57 percent of time and more than 20 percent return was 37 percent of time. So overall almost 69 percent of time stocks outperformed Treasury bill and long-term government instruments and probability of occurrences was also higher. So assumption that high return in equity market is due to few boom periods in stock market can also be negated. If we break investment periods from 1945 till date into 10-years period, stock market have out performed long term debt market 80 percent of time.

Figure- 7
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CONCLUSION With our finding we cannot guarantee relevance of buy and hold long-term investment strategy. Outcome of this strategy is ultimately depend on selection power of investor as quite possible the value stock or growth stock which we chose can underperform over next 5,10,15,20 years. There are many uncertainties which are simply inevitable. Still we can say that buy and hold strategy deal very well with it. If we own well diversify portfolio even if it consist of only stocks, we would be not overly depended on any particular sector or company. Real concern is not only volatility of market, but also the loss that can occur due to sudden or quick reaction of investor by changing long-term strategy which they may regret later. BIBLIOGRAPHY 1- Wealth report, 13 August 2012 economic times. 2- prasanna Chandra, portfolio management. 3- Fidelity research report 2012. 4- World economic forum- www.weforum.org. 5- http://www.standardandpoors.com 6- http://corporate.morningstar.com 7- www.ifa.com reports 8- http://www.dfaus.com 10- www.scottsinvestments.com/2009/04/

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