Guest contributor Ken Solow, CFP, is the author of the just-released book, Buy and Hold Is Dead (AGAIN): The Case for Active Portfolio Management in Dangerous Markets. Ken is a founding principal and chief investment officer with Pinnacle Advisory Group, a registered investment advisor located in Columbia, Md. Pinnacle provides private wealth management services for more than 500 families throughout the mid-Atlantic region and around the world, and currently manages more than $550 million in assets.
The man invoked more than any other as a proponent of buy-and-hold investing is Warren Buffett, one of the most venerated investors of our age. He's lent the subject such memorable quotes as, "Our favorite holding period is forever," and "Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years." And really, who wants to argue about investing with the Oracle of Omaha?
Actually, I do. Sort of.
In my new book, I take issue with strategic asset allocation, the buy-and-hold strategy loyally followed by elite institutional investors for the past four decades. Yet I have few if any problems with Buffett's particular long-term investment approach. (Well, aside from the caveat that waiting for value to be realized over a decade or more can kill a retirement plan. But that's the subject of an entirely different article.)
Why do I have no qualms with Buffett, when so many others cite him as an example of the strategy I've criticized? To explain, I'll use a little literary license to conjure up one of Berkshire Hathaway's
As we near the end of 2008, Charlie and I have decided to abandon our long-held acquisition strategy for businesses. As our investors know, we have always attempted to purchase businesses with consistent earnings, good returns on equity, able and honest management, and sensible prices. Beginning in 2009, we will no longer use this methodology. Instead, we will favor a new strategy that has been long used in the institutional money management industry.
For starters, we will no longer worry about the ability of our businesses to generate earnings, have a good return on equity, or have able and honest management. Charlie and I have changed our minds; we no longer believe that it is possible to buy companies at a discount. Instead, we now believe that markets are efficient, and all current share prices must constitute fair value. Berkshire will hereafter assume that all shares of every publicly traded company are available for purchase "at a sensible price."
Instead of wasting precious time analyzing the operating data for the businesses that we will acquire, we will now utilize the following new and more efficient method for selecting our acquisitions for Berkshire.
First, we will analyze as much historical return data as possible, then take the average of those returns as our assumption of how much the shares will appreciate for Berkshire in the future. Charlie and I believe that the average of the past returns will be an accurate forecast of future returns, because the forces that determined prices for the company shares in the past will never change. In addition, all of the investors who invest in this company with us will have the same investment time horizon, same tolerance for risk, same tax situation, same access to information about the company, and same cost of capital and access to credit. In fact, we attribute no risk at all to the validity of our returns forecast. The longer we own the business, the higher the probability that history will repeat itself.
Next, we will assess the volatility of the price of the company's shares, as well as the correlation of the company's price movements with other company shares that we own. We will take the long-term average of this data, along with the average historical price data for the shares, and run all the data through a computer program that will tell us what percentage of our portfolio should be allocated to our new acquisition. Instead of spending valuable time and effort determining earnings quality, return on equity, franchise value, and management capability, Charlie and I will simply let our computer program determine the right allocation for each company in our investment portfolio, and never change it again. Once more, our assumptions about the efficient nature of the investment markets and the rational behavior of investors allow us to acquire companies without analyzing their value characteristics at all, and hold them forever in exactly the same proportion to our other holdings.
We look forward to seeing you at next year's shareholder meeting. We will own exactly the same holdings, in exactly the same percentage allocations, but let's get together anyway.
Bizarro Buffett
I hope you'll recognize the patent nonsense of this fictional Berkshire investor letter. In reality, Buffett is acknowledged as one of the greatest living value investors, which is the exact opposite of being a strategic asset allocator.
While both strategic asset allocators and Buffett will hold positions for very long periods of time, they do so for totally different reasons. Buffett buys and holds because he has such a high conviction in his analysis of a company's intrinsic value, and his ability to acquire businesses at steep discounts to that value, that he's willing to patiently wait, perhaps forever, for the market to realize that value. Strategic buy and hold investors do so because they subscribe to a theory of portfolio construction that requires so many tortured and incorrect assumptions that their theory, and the strategy itself, must be considered obsolete.
For those of you who still believe that markets are efficient, and therefore, that a diversified portfolio of asset classes will properly manage risk and deliver historical average expected returns in the future, regardless of the value characteristics of the markets involved … well, I certainly hope your prayers about expected returns are answered. Personally, I'll stick with Warren Buffett on this one. As he once said, "If past history was all there was to the game, the richest people would be librarians."
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