A portfolio can earn a respectable long-term return while the person who owns it earns far less. How is that possible?
The investment return is what the portfolio earned. The investor return is what the person actually kept after buying, selling, withdrawing money, paying taxes and fees—and making decisions when the market became frightening. There can be a big difference.
Wall Street likes to show investors charts illustrating what would have happened if they had invested on a certain date, reinvested every dividend, and held on for the next 20 or 30 years. Those charts may be accurate.
But they leave out something very important. Human beings.
Real investors do not live inside a chart. They retire. They need income. They help children and grandchildren. They face medical expenses. They watch the market fall and wonder whether they will have enough time to recover.
And sometimes they panic. That is why the real question is not whether buy and hold works in a textbook. The question is whether it will work for you.
Investment Returns Measure the Investment
Investment return measures the performance of a stock, mutual fund, exchange-traded fund, index, or portfolio over a stated period. If an index averaged 10 percent a year for 20 years, that is its investment return. It sounds simple enough.
But that number often assumes the money remained invested for the entire period, every dividend was reinvested, and no one made an emotional decision along the way. Real life is rarely that neat.
An investor may put more money into the market near a high, sell after a major decline, or sit in cash waiting for the “right time” to get back in. A retiree may be forced to withdraw money while the market is down. Taxes, fees, inflation, and the timing of those withdrawals can also have a major effect on the outcome.
A strong investment return does not automatically produce a strong investor return.
Investor Returns Include the Human Element
Investor return is the return the person actually earns based on when money goes into the portfolio, when it comes out, and what decisions are made in between. I have spent more than 30 years looking clients in the eye and watching their tolerance for risk change as markets fell.
When the market is climbing, almost everyone believes they are a long-term investor. It is easy to feel comfortable with risk when your account value is going up. The real test comes when the market falls 20, 30, or 40 percent.
Consider two retirees who own exactly the same investments. One has enough cash available to cover several years of expenses and can avoid selling stocks during a bear market. The other depends on immediate portfolio withdrawals to pay the bills.
The portfolio may be the same. The outcome may not be. One investor has time to wait for a recovery. The other may be forced to sell investments after they have already fallen. That is the difference between investment return and investor return.
This can also subject and investor to sequencing-of-returns risk, and it is one of the reasons a strategy that worked while you were accumulating money may not be the best strategy for protecting it in retirement.
The way you build wealth is not always the way you protect it.
Is Buy and Hold Right for You?
Buy and hold means purchasing investments with the intention of owning them through normal market cycles instead of reacting to every headline or short-term decline.
For an investor with a long time horizon, broad diversification, low costs, and the discipline to remain invested through severe bear markets, buy and hold may work very well.
In fact, if you can watch your portfolio drop 30 or 40 percent without panicking—and you know that will still be true when you are in your seventies, eighties, or nineties—then buy and hold may be the right strategy for you.
But be honest with yourself. Have you ever had someone recommend an investment due to the performance that they had? Were your returns similar? How did you handle the ups and downs emotionally? Would you really sit quietly through a major decline? Would your spouse? Would you still be comfortable if you were retired and withdrawing money from the account every month?
Risk tolerance questionnaires are easy to complete when the market is rising. Living through a bear market is different. Wall Street often describes buy and hold as though it were effortless. Just remain invested, ignore the headlines, and wait. Sometimes that is good advice. Sometimes it becomes what I call “Buy and Hope.”
Buy and Hope is not an investment strategy. It is an emotion.
Hope is a wonderful quality in life. I believe in being hopeful, positive, and compassionate. But hope, by itself, is not a risk-management system. I’ve seen too many people bring in their 401(k) statements to me and when I congratulate them on the investment selection, they then share that they’ve just moved into most of them after a good quarter of performance. The fund may show a good return for the year, but their statement doesn’t match it because they bought after the big gains. The investment return is far greater than their investor return.
Buy and Hold Does Solve One Important Problem
The greatest strength of buy and hold is that it can prevent destructive market timing.
No one consistently knows the exact day to sell before a decline or the exact day to buy before a recovery. Investors who jump in and out of the market based on fear, greed, politics, or the evening news can do tremendous damage to their long-term results.
They often sell after prices have already fallen and buy back after prices have recovered. That is a good way to turn a temporary market loss into a permanent personal loss. By the time everything feels safe again, much of the opportunity may be gone.
But recognizing the weaknesses of market timing does not mean investors must ignore every warning sign. There is a big difference between reacting emotionally and following a disciplined process.
Active Management Should Be Disciplined, Not Reactive
Active management is often portrayed as someone sitting at a desk trying to guess what the market will do next. That is not how I view it.
Thoughtful active management is not about chasing headlines or trading for the sake of trading. It is about having a defined process for deciding what to own, when to buy it, how much to own, and what evidence would cause you to reduce or sell it.
At Studdard Financial, that process may include fundamental analysis to identify companies and sectors with improving earnings and financial strength. It may also include technical analysis—such as support and resistance levels, moving averages, trading volume, and chart patterns—to help identify potential entry and exit points.
Fundamental analysis helps us decide what may be worth owning. Technical analysis helps us evaluate when to own it.
Trailing stop-loss limits may also be used in an effort to protect gains or limit losses when market conditions change. Support and resistance levels, money flow, and other indicators like moving averages can help us decide when to buy or sell. These tools cannot eliminate risk, prevent every loss, or guarantee a profit. Nothing can.
They can, however, provide guardrails – and as a fiduciary, I believe it is my duty to make sure they exist no matter what the overall investing strategy is.
Active management has trade-offs. It requires ongoing research, judgment, consistency, and an understanding of taxes and trading costs. A stop may be triggered shortly before an investment rebounds. An active strategy may also trail the market during a fast, uninterrupted rally.
I do not expect to predict every turn in the market. Anyone who promises that should make you very nervous. The goal is to follow a clear and repeatable process—not to be perfect.
Questions To Ask Before Agreeing on an Investment Strategy
Before anyone recommends a specific type of investing strategy, whether it is passive or active, the following questions need to be answered.
When do you plan to retire and what do you plan to do with all the time you will have? During your working years, you didn’t have as much time for leisure activities as you will now have and I’ve seen that wreck retirement budgets. A house that hasn’t been remodeled in years may not have bothered you in the past, but now you’ll be home all day. Make sure your financial plan addresses home improvement projects.
How much income will you need? What inflation rate are you using? If it is based on the last 30 years, it may be too low considering current realities.
Do you have a Pension Maximization Plan that has compared Individual to Joint and Survivor Benefits? Many people assume that if they are married, checking the Joint and Survivor box is the only way to protect their spouse. A good Pension Maximization plan can confirm if this is the right choice or if there are other options that will leave the spouse better off.
Do you have a Social Security Maximization Plan that can help you decide when to take benefits? Have you included a stress test of your portfolio in the numbers? What if you retire and another dot.com type of crash occurs in your first few years of retirement?
How much cash do you have available for emergencies and near-term expenses? When you were working, there was always the chance for a raise or bonus next year. Now, you are responsible for any pay raises and that comes out of your nest egg.
What is your tax situation? Have you maximized your Roth conversion opportunities? How will the Required Minimum Distributions (RMDs) affect your overall tax bracket?
What do you hope to leave to your family? Are they able to handle an inheritance as a lump sum or would it be better to give them small amounts while you’re still living to see how they handle it?
And perhaps most important: How much of a decline can you tolerate before fear takes over? I’ve had clients that allocate part of their portfolio to passive investing because they swear they won’t sell if the market crashes only to have them change their mind as they age and sell out near the bottom.
The Bottom Line
I am not interested in getting into an academic argument about passive versus active investing. Both approaches have strengths. Both have weaknesses. And neither one is right for everyone. Many of my clients use a little bit of both. What matters is whether your strategy fits your goals, your stage of life, your need for income, and your actual ability to live with losses.
Not your hypothetical ability. Your actual ability.
The best investment strategy is not the one that looks perfect on a long-term chart. It is the one you understand, the one you can follow, and the one designed to help you protect the wealth you worked a lifetime to build.
Because investment returns are only numbers on a page.
Investor returns are personal.
About Byron L. Studdard, CFP®
Byron L. Studdard is a CERTIFIED FINANCIAL PLANNER® professional and the founder of Studdard Financial – a fee-only fiduciary registered investment adviser serving clients from coast to coast from offices in Sarasota, FL and Memphis, TN. For more than thirty years, he has provided personalized investment advice, retirement planning guidance, social security maximization strategies, and intergenerational wealth-transfer support to clients seeking disciplined, trustworthy financial oversight. His writing has been featured on the websites of ABC News, Good Morning America, and Yahoo. He can be reached at Byron@StuddardFinancial.com.
Important Disclosures:
All information provided is for educational purposes only and does not constitute investment, legal or tax advice; an offer to buy or sell any security or insurance product; or an endorsement of any third party or such third party’s views. The information contained herein has been obtained from sources we believe to be reliable but is not guaranteed to be accurate or complete. Studdard Financial, LLC does not offer tax or legal advice, but might refer clients to independent accounting, tax, or legal professionals.
Whenever there are referrals to other professional advisors, or references or hyperlinks to third-party content (including but not limited to tax and legal), this is intended to provide additional perspective and should not be construed as an endorsement of any services, products, guidance, individuals, or points of view. All examples are hypothetical and for illustrative purposes only. Please contact us for more complete information based on your personal circumstances and to obtain personal individual investment advice.
Carefully consider your investment objectives, risk factors, and charges and expenses before investing. Investing involves risk, including possible loss of principal. Consult your own advisor about the implications of investing. Diversification and asset allocation may not protect against market risk. Past performance is never a guarantee of future returns. Investing in foreign stock markets involves additional risks, such as the risk of currency fluctuations.
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