20 comments on “Advice for Buy-and-Hold Investors

  1. Your expectation is that this portfolio will beat the market by 3% over the next decade?

    Beating the market by 3% is not really “beating”. It’s *absolutely crushing*. Like, you’re-the-legit-Bernie-Madoff kind of crushing. I believe that overweighting in small-caps and emerging markets might generate these kind of returns under the right conditions. I also suspect they would underperform by 3% in fairly typical bad conditions, whether the funds were “low volatility” or not.

    This looks like a portfolio designed to take advantage of high volatility, in fact. Which might be a great portfolio for a sensible, informed buy-and-hold investor, but that portfolio would probably need a hefty bond or cash-equivalent portion that gave you the ability to re-balance during frequent, significant dips and surges.

  2. Re: https://www.reddit.com/r/investing/comments/3mn26x/is_this_bayesian_advice_for_buyandhold_worth/:

    Diversity wasn’t my top goal here. I highly recommend diversity when it’s available at virtually no cost (e.g. internationally diversified funds instead of funds that focus on whatever country you happen to live in).

    I haven’t found much reason to worry about modest deviations from optimal diversity when I’m pursuing strategies that are designed to be low risk. For the low volatility and fundamental weighting strategies, I believe they have a tendency to underweight stocks that will crash, which offsets the risks associated with moderately lower diversity.

    Still, I should have looked at the industry weightings, and if I had done so, I would have suggested somewhat different weightings: less XSLV, and more PDN. 15% XSLV and 25% PDN would bring finance down from about 34% to about 32% according to the numbers that TheLateOne provided, without sacrificing the benefits that I’m looking for.

    Have you got the grit (or apathy perhaps) to walk away from your portfolio for years at a time in order to maximize your long term returns?

    That is close to a key question. My post was designed for people who, at most, rebalance their portfolio once or twice a year to ensure that one of the funds doesn’t grow into an unusually large fraction of their portfolio. (I expect such rebalancing to be desirable, but not very important, for people who are following the strategy I suggested here). Such investors shouldn’t try to analyze industries.

    There are lots of people who think they can do better, and that they can evaluate individual industries and select ones that are safer and/or likely to outperform. Most such people will be wrong, and won’t follow the advice I have here.

    I’m unclear whether TheLateOne believes that he or she knows better how to pick industries than automated strategies for low volatility and fundamental weighting. The strategies have good long-term track records. I don’t see a track record for TheLateOne.

    I consider it quite reasonable to believe that this is a good time to overweight banks and real estate. The problems of 2008 are still fairly vivid in the minds of enough people that banks and real estate companies are less likely than normal to take the risks that they took in 2003-2007. And investors are likely being cautious about buying those industries due to those same vivid memories. I expect low volatility and fundamental weighting strategies to take advantage of such effects

    This fund focuses on spinoffs so presumably most of the alpha comes from a fund manager’s analysis of the deals happening.

    No, the alpha comes from a pattern of spinoffs being underpriced. It invests in all spinoffs that meet some basic constraints such as size and timing.

  3. Thanks for replying.

    I was already planning to use your advice, but the criticism, particularly the “actually it’s high-volatility” claim, gave me some pause.

  4. Thank you for making this post.

    You said, “Take a few minutes to imagine that you will be influenced by the mood of other investors to be pessimistic when the market has been doing poorly, and optimistic when the market has been doing well. Also imagine that you will have more money available to invest when the market is high than when it is low. If you’re confident that you can avoid these problems, please stop reading this post – you’re either good enough to not need my advice, or deluded enough that you ought to start somewhere else.”

    I’m confused. For one, I think I can avoid the problems you mentioned. However, I don’t think I’m good enough to not need your advice, for I don’t know much about investment. However, I’m having a hard time believing I’m deluded, since in the past when the market did poorly or well in the past I had no temptation to change my investing strategy or do anything else harmful investment-wise, nor do I see any reason why I would have.

    Any thoughts to help me deal with my confusion would be appreciated.

  5. None of the stocks you recommend exploit all of the inefficiencies you mentioned, and I’m wondering why you don’t recommend investing in a stock that does. Is there no such stock? If so, why not?

  6. SRTQ,
    From what little information you provide about yourself, I’m guessing you don’t have enough evidence to justify being confident about what you’ll do. There are probably a few people who are exceptions to that heuristic, but there are a much larger number who are mistakenly confident in their abilities. Unless you have more unusual evidence about yourself than you’ve indicated, you should assume you’re in the latter group, and should therefore be more uncertain about how well you will follow a strategy.

    I expect that there’s no etf that combines all of these strategies. It’s easy enough for investors to buy several etfs, and plenty of differing opinions on which strategies to use and how to weight them, so I don’t expect there’d be lots of demand for a fund that combined multiple strategies.

  7. Peter,

    Thank you for the response.

    The issue with buying multiple etfs that exploit different inefficiencies is that I don’t see how it would have higher returns in expectation than buying just the one etf that exploits the most exploitable inefficiency (though I see how it would have lower risk). E.g. if you invest 50% of your funds into an etf that exploits inefficiency a and in expectation beats the market by 1% and you invest 50% of your funds into an etf that exploits inefficiency b and in expectation beats the market by 3%, then in expectation I think you would be the market by 0.5 * 1% + 0.5 * 3% = 2%. But if you instead invest in an etf that exploits both inefficiencies a and b by only purchasing a stock if that stock is underpriced due to both inefficiency a and b, then I would naively think I would have a return that beats to market in expectation by roughly 1% + 3% = 4%. There being correlations between the inefficiencies might make the etf that exploits both of them have a return that’s less than 4% in expectation, but I suspect it would still be much greater than 3%. That said, I have extremely little knowledge about investing, so this might be nonsense. Am I missing something?

  8. SRTQ,

    Yes, that explains a real advantage of combining strategies. Half of my recommended portfolio consists of etfs that combine a smallish-cap strategy with another strategy, and I would do more of that if appropriate etfs existed.

    But I’d still recommend a little diversification of strategies, for the same reasons diversification is good in general. I see that I didn’t do a good job of explaining the value of diversification – I recommend the second post in this thread for a good summary (and also a good description of how to evaluate leverage).

    There are sometimes technical difficulties with combining strategies – I suspect there are often no recent spinoffs with small capitalization, and if there were an etf that bought spinoffs within a month of when they started trading, they’d have a poor estimate of the volatility. But existing etfs aren’t pushing that limit.

    Robo-advisors sound like they might be able to implement the equivalent of a customized etf at a possibly affordable cost. I wasn’t familiar with them when I wrote the post, but I’m guessing that people who can afford to spend 20+ hours setting up a robo-advisor account should try using that to combine several strategies. (I’ve met someone from AntiGravity Investments, and I have a vaguely favorable opinion of them, but I’m unclear about whether they’re open to the public yet).

  9. Peter,

    Thank you for the information.

    But I’m confused about why people seem to be leaving so much low-hanging fruit unpicked.

    First, I don’t understand how these market inefficiencies that allow you to beat the market continue to exist despite being public information. Why don’t professional investors exploit these inefficiencies until they no longer exist? I understand that they are exploited to some extent once they are discovered, but based on what little research I found on the topic, they don’t seem to go away completely.

    Second, I still don’t understand why there doesn’t seem to be an etf that combines all of the strategies. I understand that due to diversification it probably wouldn’t be a good idea to invest *all* of your money in such a fund, and I understand that such an etf might not be able to exploit every single inefficiency all the time. But I’m having a hard time understanding why, despite there being thousands of etfs, not a single person tried making one that exploits all these strategies. Are the risks really so great, and the additional returns really so small, so as to make combining more than 2 strategies *never* worth it? Did people really think, “Hey, why try making an etf that exploits multiple scientifically-back market inefficiencies when an [etf for the fertilizer industry](https://www.kiplinger.com/tfn/ticker.html?ticker=SOIL) is so much more promising!?”?

  10. SRTQ:

    To your first question. That depends on the strategy. Something like the short anomaly discussed in this article can’t be arbitraged because it is risky. An institutional investor would have to take a very large position in these stocks to get rid of that risk, causing them to be underdiversified and thus subject to those stocks’ idiosyncratic risk.

    Regarding an “anomaly” like the size or value premia. There is very convincing theory and empirical evidence that suggest these reflect risk, not “mispricing.” Any failure of traditional model like the CAPM that were traditionally used to show these stocks earn “excess” returns will show up in factors like size and value. https://academic.oup.com/rfs/article-abstract/8/2/275/1589425 is one the original papers making this argument. It then becomes a very complex matter that takes a lot more thought to then decide if you should be overweighting your portfolio towards size/value. (If you are curious, I can expand on that)
    Examples of forces that can lead to size/value premia that are not due to mispricing:
    Stochastic volatility, tail risk aversion, dynamic changes in market-wide investment prospects, time-varying risk aversion

    Regarding your question on ETFs, there are many funds that focus on each individual one. Mutual funds trade on multiple of these sorts of premia. Again, though, there is CONVINCING empirical evidence that these are just types of risk. Thus, would I recommend my friend invest in these ETFs, rather than just a total-market index? Well, that will depends on their age, income, risk aversion, etc.

  11. I hope I’m not being annoying with my questions, here. But Eliezer Yudkowsky in *Inadequate Equilibria* wrote:
    “If I had to name the single epistemic feat at which modern human civilization is most adequate, the peak of all human power of estimation, I would unhesitatingly reply, “Short-term
    relative pricing of liquid financial assets, like the price of S&P 500 stocks relative to other S&P 500 stocks over the next three months.” This is something into which human
    civilization puts an actual effort.
    * Millions of dollars are offered to smart, conscientious people with physics PhDs to induce them to enter the field.
    * These people are then offered huge additional payouts conditional on actual performance—especially outperformance relative to a baseline.
    * Large corporations form to specialize in narrow aspects of price-tuning.
    * They have enormous computing clusters, vast historical datasets, and competent machine learning professionals.
    * They receive repeated news of success or failure in a fast feedback loop.
    * The knowledge aggregation mechanism—namely, prices that equilibrate supply and demand for the financial asset—has proven to work beautifully, and acts to sum up the wisdom of all
    those highly motivated actors.
    * An actor that spots a 1% systematic error in the aggregate estimate is rewarded with a billion dollars—in a process that also corrects the estimate.
    * Barriers to entry are not zero (you can’t get the loans to make a billion-dollar corrective trade), but there are thousands of diverse intelligent actors who are all individually
    allowed to spot errors, correct them, and be rewarded, with no central veto.
    This is certainly not perfect, but it is literally as good as it gets on modern-day Earth.

    I don’t think I can beat the estimates produced by that process. I have no significant help to contribute to it. With study and effort I might become a decent hedge fundie and make a
    standard return. Theoretically, a liquid market should be just exploitable enough to pay competent professionals the same hourly rate as their next-best opportunity. I could potentially
    become one of those professionals, and earn standard hedge-fundie returns, but that’s not the same as significantly improving on the market’s efficiency. I’m not sure I expect a huge
    humanly accessible opportunity of that kind to exist, not in the thickly traded centers of the market. Somebody really would have taken it already! Our civilization cares about whether
    Microsoft stock will be priced at $37.70 or $37.75 tomorrow afternoon.”

    It seems like Eliezer would disagree with your assessment that casual investors can predictably beat the market. I’m wondering what your thoughts on this are.

  12. Eliezer and I mostly agree: the pricing of stocks with large market capitalization is handled much more wisely than monetary policy or nutrition.

    But there’s a finite amount of money available to the best investors, and they’ve got a finite amount of attention. I’ve tried to focus on strategies that would take large amounts of money to eliminate the last percentage point of above-market returns. And I expect the best investors to mostly aim for strategies that are a bit more profitable than the ones I recommend.

  13. I understand you and Eliezer agree that stocks with large market capitalization are not mishandedled horribly. But you still seem to think one can crush the market by following a simple, publicly available strategy. And Eliezer seems to think that’s not possible, as signified by him saying “I don’t think I can beat the estimates produced by that process”. Am I right in that you two disagree about this? I’m not sure if MIRI owns any stocks, but if MIRI does and Eliezer is wrong, I think we should tell them.

  14. Peter,

    Thanks for this post, I found it really informative and helpful.

    Looking at your recommendations with the benefit of hindsight, they seem to have on average significantly underperformed the stock market over the last 5 years or so.

    Do you think that this is just variance and that over the long term these strategies will still outperform, or have you changed your mind about their edge?

  15. Thanks for all the links, interesting stuff.

    It does seem to me that Colby’s and your article are slightly outdated at this point. Both Russell 2000 and Russell 2000 Value have outperformed the S&P 500 in the past few months. So the gap between large growth stocks and small value stocks has narrowed a bit.

    At the same time XSLV and IDLV seem to have underperformed the Russell Index and still are below their pre-pandemic highs. Do you have any thoughts why this might be? I’d guess it has to do with the low-volatility factor.

    Also if it is true that a few large companies were overvalued at the end of summer and now most other stocks are catching up, does that imply the stock market is overvalued as a whole? Or do you think some macro factors have changed and the stock market is valued fairly?

  16. I expect low volatility funds to underperform when bubbles are inflating, and outperform when bubbles are deflating. I haven’t seen much deflating of bubbles.

    The stock market is overvalued in the sense that most market-cap weighted funds look expensive. I’m unsure whether it’s overvalued in the sense of a randomly chosen US stock being overpriced. I see plenty of cheap-looking stocks trading on the Hong Kong exchange, but I don’t know whether an ETF would enable you to buy those.

  17. I really like your guide. But is it applicable for Outside US traders?
    Because I’m Indian and I’m using Kotak Securities to trad in global stocks.

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