Is Your Investment Strategy Going Extinct?

Nothing lasts forever, including the effectiveness of some investment strategies. True, some basic ideas like "buy the stocks of high-quality companies when they're trading cheaply" seem to operate with no expiration date, but other strategies seem to work only for a while, before reverting back to market-average or worse returns. Let us examine some of the strategies that may be on the way out. (Avoid taking premature profits or running losses by setting appropriate exit points, see A Look At Exit Strategies.)

TUTORIAL: Stock-Picking Strategies

The Safe Haven
Whenever the markets turn rough and some sector happens to go up (or go down less), investors and commentators are more than happy to anoint a new "safe haven" for investors. Gold has been a safe haven at many points in history. Bonds have been safe havens, as have dividend-paying stocks, utility stocks, consumer goods stocks and so on. (For related reading, see The Advantages Of Bonds.)

For example, healthcare was supposed to be a safe haven. Yet, during the recession in the late 2000s healthcare underperformed as pharmaceutical companies suffered from patent cliffs and medical device companies bore the brunt of lower patient visits and tight hospital capital budgets.

That, then, is the problem – every crisis is different, as is the optimal path through that crisis. What's more, people often underestimate the importance of timing when it comes to picking a safe haven. If an investor has a firm conviction that "Asset X" is going to be a safe place to weather the next storm, he or she would do well to get in early so that the other investors piling in later push up the price. Likewise, getting out on time is important as well – once the danger passes and everybody wants out of the safe haven, prices can drop so quickly that those slow to leave end up holding the bag.

Arbitrage
Arbitrage investing is all about making dollars a few pennies at a time – trading on the small discrepancies in prices between exchanges or an announced deal and current valuations. Unfortunately, the increased liquidity and access to markets has largely eliminated these easy profits. Arbitrage is still possible, but it tends to only be profitable for traders with the infrastructure to make large trades at lightning speed. This is not something that can be handled by a friendly retail internet broker. (For related reading, see Trading The Odds With Arbitrage.)

Dogs of the Dow
The Dogs of the Dow offered a simple value-oriented approach to investing. Investors would choose from those stocks making up the Dow Jones Industrial Average, selecting for a portfolio on the basis of the highest dividend yields and lowest stock prices, with annual rebalancing. In theory, this offered up a portfolio of relatively undervalued large-cap companies that should outperform the market (based in large part on the assumption that those dividend yields should revert to the mean).

The evidence is mixed as to whether the Dogs of the Dow strategy ever worked as advertised; some academics have made the case that the advertised results were a product of data mining and not reproducible in practice. In any case, there have been several public attempts to implement the strategy and they have failed. Whether that failure is a product of the markets simply filling in a previously unknown gap or whether the strategy never worked at all is moot – the point is that it no longer seems to work. (For related reading, see Barking Up The Dogs Of The Dow Tree.)

Guru of the Month
From time to time an investment advisor pops up with a sure-fire strategy for making money in the market. Many of these approaches are outright scams, but some are sincere attempts to offer a combination of formulas and stock characteristics that seem to lead to market outperformance.

The problem with many guru approaches, the legitimate ones at least, is that they exploit an inefficiency in the market. Once enough people know about an inefficiency, it tends to disappear fairly quickly. In fact, if there is some combination of return on equity, margins and EV/EBITDA that spells investment success, investors will program computers to jump on those opportunities. Moreover, other investors who try to think one step ahead will anticipate stocks that will soon sport those characteristics to take advantage of the automated market jump these stocks can expect from the computer programs – and on it goes. With all of that buying activity, the stocks are soon revalued and the market-beating potential vanishes.

Deep Value Investing
It is probably inaccurate to describe deep value investing as going extinct; most likely the last specimens died in captivity long ago. After reading some of the seminal works of investment strategy, Benjamin Graham's "Security Analysis" and "Intelligent Investor," it used to be possible to find stocks trading below the value of the net current assets on the balance sheet. Likewise, companies often held assets worth far in excess of their stated value and the market capitalization of the company. There were profitable trades to be made by finding these stocks and waiting for the market to realize the value. (For more on value investing, see The Value Investor's Handbook.)

Now, though, the market moves much faster and information is both more easily available and available more quickly than before. As a result, companies with $1 per share of cash and a $0.50 stock price just do not stick around for long. What's more, companies have gotten savvier about singing their own praises and maximizing the market value of both their assets and stocks.

Invest Your Age
There is a school of thought that holds that investors would do well to allocate their portfolio according to their age by matching their portfolio weighting to bonds to their age in years. In other words, a 30 year old investor should hold 30% of his or her assets in fixed income, while a 60 year old investor should have double that allocation.

Back in the days of pensions and defined-benefit retirement plans, maybe this wasn't such bad advice.

Nowadays, though, it seems like a dangerously over-conservative way to invest. What's more, people are living longer than ever before but still retiring at basically the same age (around 65). That means that they need more money in their portfolio at the time of retirement, and must continue to earn good returns on that money throughout retirement or risk running out of money.

Though it is true that stocks are generally more volatile than fixed income investments, that volatility cuts both ways; it is relatively rare for long-term equity investors to underperform fixed income. Worse still, with the corrosive and often underreported impact of inflation on fixed income assets, over-allocation to fixed income can lead to a worker having too little money saved away for retirement. (For related reading, see Young Investors: What Are You Waiting For?)

Buy-and-Hold
Perhaps the most controversial idea is that buy-and-hold investing is dead. The idea here seems to be that markets are so quick and efficient in addressing undervaluation, there is simply no chance that a stock can be undervalued for years at a time and worth holding for the long haul.

This notion seems to have really gained currency in the wake of the tech bubble, and it is certainly possible to see a few points in its favor. After all, anybody who bought a tech stock like Cisco (Nasdaq:CSCO) or Microsoft (Nasdaq:MSFT) during the bubble is still sitting on a loss. Likewise, anyone who bought and held a high-quality bank stock like US Bancorp (NYSE:USB) or M&T Bank (NYSE:MTB) through the housing bubble and credit crisis saw a terrifying drop and still is not whole. (For related reading on the credit crisis, see The Fuel That Fed The Subprime Meltdown.)

Here's the problem – markets have always been turbulent and buy-and-hold does not mean the same as buy-and-go-to-sleep. Those buying tech stocks in the 1999-2000 timeframe were almost always paying very rich multiples and buying into (implicitly or explicitly) market growth projections that defied reality. Likewise, it took a certain amount of deliberate ignorance to not see the extent of the housing/credit bubble and the probable impact on financial companies.

I would argue that buy-and-hold still works, but I will not disagree that it is perhaps more difficult than before. Buying a hot stock in a hot industry and holding on is probably a bad idea, but buying an incredibly well-run company and holding it for years at a time can still produce above-average returns so long as an investor does not continue to hold past a point of unreasonable valuation.

The Bottom Line
Investors should never just hit the snooze button and assume that what worked in the past will always work in the future. That is particularly true in the case of magic formulas or conventional wisdom. Independent investors that invest on the basis of sound value principles likely have little to worry about, but investors following the flavor of the month need to always be aware that time moves on and often leaves these methodologies in the dustbin. (Discover more investment strategies. For more, see Investment Strategies For Volatile Markets.)

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