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5/13/2007 7:51:19 PM

[Comparison of various asset allocation models from 1970 to 2007]
[Porfolio 1 from $100,000 to 3,874,304 AnnRet = 10.4%, StdDev 11.4%]
[Porfolio 2 from $100,000 to 3,801,359 AnnRet = 10.3%, StdDev 10.8%]
[Porfolio 3 from $100,000 to 4,326,748 AnnRet = 10.7%, StdDev 10.0%]
[Porfolio 4 from $100,000 to 5,271,091 AnnRet = 11.3%, StdDev 11.2%]
[Porfolio 5 from $100,000 to 6,685,735 AnnRet = 12.0%, StdDev 11.2%]
[Porfolio 6 from $100,000 to 9,656,542 AnnRet = 13.1%, StdDev 10.9%]

[Note: Charts and Graphs not available in this version]

The ultimate buy-and-hold strategy
Written by Paul Merriman

Thursday, 22 February 2007

In this update to one of the most important items in our article library, Paul Merriman shows how a series of simple but powerful concepts can put patient investors far ahead of the crowd. This 2007 update adds returns from 2006 plus a new portfolio.

If you are a serious investor, this article could be one of the most important things you'll ever read. I'm going to show you the very best investment strategy that we know, the strategy that's behind the way we manage the majority of the money we invest for clients.

Letís start by looking at whatís new: First, we have added a new equity asset class, U.S. real estate funds. Second, weíve refined our fixed-income recommendations. Third, we have updated all our returns with results from 2006.

This strategy is best understood with a brief history lesson. When I founded Merriman Capital Management in 1983, millions of investors had just suffered large market losses over a period of almost 20 years. In fact, from 1966 through 1982, the Standard & Poorís 500 Index had produced negative returns after accounting for inflation.

We initially offered only strategies that used market timing systems to actively manage risk. The systems were designed to give investors a chance to participate in the equity market without the high risks of buying and holding no matter what.

In 1992, as we began helping clients with more and more of their money, it became increasingly clear that much of that money was invested without timing. We sought Ė and found Ė a buy-and-hold strategy that we believed would be worth recommending.

After all these years, we like this strategy so much that we call it the Ultimate Buy-and-Hold Strategy, as the title of this article indicates.

We donít use that word ďultimateĒ casually. I donít claim this is the best investment strategy in the world. But it is the best that weíve found, and we are continuing to refine it. I believe almost every investor can use this strategy to increase returns and reduce risk.

This is suitable for do-it-yourself investors as well as those who want to hire professional money managers. It works in small portfolios (although not tiny ones) as well as large portfolios. Itís easy to understand and easy to apply using low-cost no-load mutual funds.

You should know that we did not invent this strategy. It has evolved from the work of many people over a long period, including some winners and nominees for the Nobel Prize in economics.


In theory, a perfect investment strategy would be cheap, easy and risk-free. It would make you fabulously rich in about a week. Tax-free, of course. We havenít found that combination, and we donít expect to find it. But in the real world, this is the best substitute we know.

Over the long run, the Ultimate Buy-and-Hold Strategy produces higher returns than the investments most people hold. It does so at lower risk, with minimal transaction costs. Itís mechanical, so it doesnít require investors to pore over investment newsletters, pick stocks, find a guru or understand the economy.


Even though this strategy is based on academic research, itís really fairly simple. If I had to reduce it to a single sentence, hereís what I would say: The Ultimate Buy-and-Hold Strategy uses no-load mutual funds to create a sophisticated asset allocation model with worldwide diversification and the addition of value stocks, small company stocks and real estate funds to a traditional large-cap growth stock portfolio.

If you think you already know what that means and youíre tempted to skip the rest of this article, I hope youíll resist that temptation. I have some compelling evidence to show you. If you apply this diligently, doing so could make a big difference in your future and your familyís future.

If there is a ďcatchĒ to this strategy, itís availability. You cannot buy it in a single mutual fund. You can put it together approximately using Vanguardís low-cost index funds; but Vanguard doesnít offer every piece of it. You can get each of the individual pieces, but you may have to open more than a single account and you might have to pay more in expenses than I would regard as ideal.

In my view, the ultimate way to implement this ultimate strategy is to hire a professional money manager who has access to the institutional funds offered by Dimensional Fund Advisors. (More on that later.)


The Ultimate Buy-and-Hold Strategy is based on more than 50 years of research into the question: What really makes a difference to investment results? Some of the answers may surprise you. The people behind this research include Merton Miller, a 1990 Nobel laureate; Rex A. Sinquefield, who started the first index fund; and Eugene F. Fama, Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago graduate school of business.

Their expertise has been pooled in a company that Sinquefield started in 1981, Dimensional Fund Advisors, to give institutional investors a practical way to take advantage of their research. Today, Dimensional manages more than $120 billion of investments for pension funds, large corporations and a family of terrific mutual funds that are available to the public through a select group of investment advisors.


Before we get into the meat of this strategy, there are a few things you should know. Every investment and every investment strategy involves risks, both short-term and long-term. That means investors can always lose money. The Ultimate Buy-and-Hold Strategy is not suitable for every investment need. It is based on long-term returns. But it wonít necessarily do well in every week, every month, quarter or year. There will be times when it loses money. You have been warned.

Like most worthwhile ways to invest, this strategy requires investors to make a commitment. If you are the sort of investor who dabbles in a strategy to check it out for a quarter or two, donít even bother with this. You will be disappointed, and youíll be relying entirely on luck for such short-term results.

I am often asked how this strategy did last year or how itís doing so far this year. Some people tell me they think investors should be in some particular asset over the next few months or the next year. Almost always, this is the result of something they have read or heard without checking it out thoroughly on their own. These people arenít likely to succeed with this ultimate strategy because they are focused on the short term.

The Ultimate Buy-and-Hold Strategy is not based on anything that happened last year or last quarter. Itís not based on anything that is expected to happen next quarter or next year. It makes absolutely no attempt to identify what investments will be ďhotĒ in the near future. If thatís what you want, you should look elsewhere, because you wonít find it here.

But if you want superior long-term performance that doesnít require much maintenance once it is set in motion, you have come to the right place.


The most important building block of this strategy is your choice of assets. Many investors think success lies in buying and selling at exactly the right times, in finding the right gurus or managers, the right stocks or mutual funds. In short, in being in the right place at the right time. Those are elements of luck, and they can work against you just as much as they can work for you.

Hereís the truth: Your choice of asset classes has far more impact on your results than any other investment decision you will make. I know this flies in the face of a lot of conventional wisdom and almost all the marketing hype on Wall Street, so I want to repeat it. Your choice of the right assets is far more important than exactly when you buy or sell those assets. And itís much more important than finding the very ďbestĒ stocks, bonds or mutual funds.

Dimensional Fund Advisors studied the returns of 44 institutional pension funds with about $450 billion in assets over various time periods averaging nine years. The study concluded that more than 96 percent of the variation in returns could be attributed to the kinds of assets in the portfolios. Most of the remaining 4 percent was attributable to stock picking and the timing of purchases and sales.


So how do you choose the right asset classes? Iíll show you exactly how, illustrating the process in a series of pie charts. Weíll start with Portfolio 1, a very basic investment mix. Assume the whole pie represents all the money you have invested. This version of the pie has only two slices, one for bonds (labeled the Lehman Govt./Corp. Index) and one for equities (labeled the Standard & Poorís 500 Index).

(The returns cited throughout this article are not those of our managed strategy and do not reflect any potential transaction costs, fees or expenses that investors must inevitably pay. These figures are returns of asset classes, not specific investments.)

Portfolio 1ís 60/40 split between equities and bonds is the way that pension funds, insurance companies and other large institutional investors have traditionally allocated their assets. The equities provide long-term growth while the bonds provide stability and income.

Let me say up front that we donít believe 60 percent equity and 40 percent fixed-income is the right balance for all investors. Many young investors donít need any bonds in their portfolios. And many older folks may want 70 percent or more of their portfolios in bonds. However, the 60/40 ratio of Portfolio 1 is a very good long-term investment mix. Itís an industry standard, and Iíll use it throughout this article to illustrate my points.

For 37 years, from January 1970 through December 2006, this portfolio produced a compound annual return of 10.4 percent. Thatís not bad at all, especially considering this period included three major bear markets. I believe that return should be more than enough to let most investors achieve their long-term goals.

Therefore, for this discussion I will use a long-term annual return of 10.4 percent as a standard or benchmark against which to measure the strategy Iím presenting. Youíll see this strategy unfold in a series of pie charts as we split the pie into thinner and thinner slices by adding asset classes.

Remember that we also must look at risk. Adding return while also increasing risk is certainly possible, but itís not what weíre after here. We want risk to remain the same Ė or ideally, to decline. Therefore, another measure Iíll use to gauge this strategy is standard deviation.

Standard deviation is a statistical way to measure risk. (If you want to understand this statistically, there are plenty of resources on the web that will tell you how itís defined and applied.) In order to understand the attractiveness of the Ultimate Buy-and-Hold Strategy, what you need to know is that a lower standard deviation is better, indicating a portfolio that is more predictable and less volatile. The standard deviation of Portfolio 1 is 11.4 percent, so weíll use that as the benchmark.

Hundreds of thousands of investors would be better off with Portfolio 1 than they are with their current portfolios, which offer too little diversification and too much risk. If those investors did nothing more than adopt this simple mix of assets Ė which is easily duplicated using a couple of no-load index funds, they would be more likely to achieve their long-term investment goals.

Because of that, and because it is used by institutional investors who cannot have much tolerance for getting things wrong, I believe Portfolio 1 is a relatively high standard from which to start. In my view, anything worthy of being called an ďultimateĒ strategy must beat Portfolio 1 in two ways. It must be worthy of a reasonable expectation that it will produce a return higher than 10.4 percent and at the same time have a standard deviation lower than 11.4 percent.

Most of the Ultimate Buy-and-Hold Strategy is concerned with the 60 percent equity side of the pie. Thatís where the main focus will be in this article. But itís very important to get the fixed-income part of this strategy right.

Most people include bond funds in a portfolio to provide stability, which can be measured by standard deviation. Many investors also expect bond funds to produce income, which of course is part of any investorís total return. The more bonds a portfolio holds, the more stability it is likely to have Ė and the less growth it is likely to produce.


Whether your portfolio is heavy or light on bonds, it matters what kind of bonds you own. In general, longer bond maturities go together with higher yields and higher volatility (higher standard deviation, in other words). However as you extend maturities beyond intermediate-term bonds, the added volatility (risk) rises much faster than the additional return.

In the past, we recommended short-term bond funds for this part of the portfolio. After more study, we have refined our approach two ways. First, the fixed-income portfolio now is exclusively in government fixed-income funds. Second, this segment of the portfolio is now made up of 50 percent intermediate-term funds, 30 percent short-term funds and 20 percent in TIPS funds for inflation protection. (TIPS funds invest in U.S. Treasury inflation-protected securities, which automatically adjust their interest payments and their value to changes in the Consumer Price Index.)

For a variety of reasons, we expect this combination to produce slightly higher returns with a little bit of additional risk. In an all-fixed-income portfolio, this would leave us with that higher risk. But because the additional risk comes from the longer term of the bonds (instead of from the possibility of a corporate default), this extra risk is non-correlated with the stock market. That means that when we combine this fixed-income mix with a diversified equity portfolio, the volatility of the entire portfolio goes down.

I know itís counter-intuitive to think you can reduce risk by adding risk. But in this case, as the result of careful thought and study, we believe that you can do just that. This is what I call ďsmart diversificationĒ at work, and weíll encounter it again when we examine the equity side of the portfolio.

Why do we exclude corporate fixed-income funds? In a nutshell, we believe in taking calculated risks on the equity side of the portfolio while being very conservative on the fixed-income side. U.S. Treasury securities are the safest securities in the world; they virtually eliminate the risk of default. Because the default risk of corporate bonds is highly correlated with a good part of the risks on the equity side of the portfolio, the default risk of corporate bonds would increase the overall volatility instead reducing it.

The result of these changes is Portfolio 2. From 1970 through 2006, this combination had an annualized return of 10.3 percent and a standard deviation of 10.8 percent. This change gives the portfolio more stability (less risk) at very close to the same return. (Youíll see the exact difference, 72,945, reflected in the hypothetical growth of $100,000.)

This refinement from Portfolio 1 is modest. But thereís much more to come as we tackle the 60 percent of the portfolio devoted to equities.


Virtually all serious investors are familiar with the long-term attraction of owning real estate. When this asset class is owned through professionally managed real estate investment trusts known as REITs, it can reduce risk and increase return.

Over the period of this study, REITs compounded at 16.7 percent, far outpacing the Standard & Poorís 500 Index. This was an unusually productive period for REITs, and academic researchers expect the future returns of real estate and of the S&P 500 Index to be very similar to each other Ė though not as high as they were in this period.

As you will see, when REITs make up one-fifth of the equity part of this portfolio (in Portfolio 3), the annual return rose to 10.7 percent and standard deviation (risk) fell to 10 percent. At this point we have accomplished our objective of adding return and reducing risk. Over this long period, the bottom line is an additional $452,443 in cumulative return. This is an excellent start, but the best is yet to come.


The standard pension fundís equity portfolio, shown here in Portfolios 1 and 2, consists mostly of the stocks of the 500 largest U.S. companies. These include many familiar names like ExxonMobil, General Electric, Citigroup, Microsoft, Pfizer and Proctor & Gamble. Each of these was once a small company going through rapid growth that paid off in a big way for early investors. Microsoft is a classic case from the last 20 years.

Because small companies can grow much faster than huge ones, a fundamental way to diversify a stock portfolio is to invest some of your money in stocks of small companies.

To accomplish this, the next step in building the Ultimate Buy-and-Hold Strategy is to add small-cap stocks to take another one-fifth of the equity part of the portfolio. To represent small-cap stocks, we have used the returns of the Dimensional Fund Advisors U.S. Micro Cap Fund, which invests in the smallest 20 percent of U.S. companies.

The result is Portfolio 4, a pie that now has four slices and which from 1970 through 2006 produced an annualized return of 11.3 percent. Itís true that the risk level (measured by standard deviation) rose from Portfolios 2 and 3, but itís still lower than that of Portfolio 1. With these three changes, we added nearly $1.4 million to the cumulative return. Thatís an increase of 26.5 percent.

Iíd like you to pause for a moment and think about that additional return of $1.4 million. That extra return is worth nearly 14 times the entire initial investment of $100,000. How much work did it take to capture that extra return? Iím betting you could set this up with less than 20 hours of your time. But letís be very conservative and say that it took you 40 hours, a full standard work week. Divide the extra return by those hours and the payoff amounts to $34,920 per hour. I donít know anywhere else you can get paid that much for your time. If you do, I hope youíll let me know! Could I now interest you in doubling that extra return, something I am sure you can do within the allotted 40 hours of the calculation above?


The next step is to differentiate between what are known as growth stocks and value stocks. Typical growth investors look for companies with rising sales and profits, companies that either dominate their markets or seem to be on the brink of doing so. These companies are typical of those in the S&P 500 Index of Portfolio 1.

Value investors, on the other hand, look for companies that for one reason or another may be temporary bargains. They may be out of favor with big investors because of things like poor management, weak finances, new competition or problems with unions, government agencies and defective products.

Value stocks are regarded as bargains that will return to their supposedly ďnormalĒ levels when the market perceives their prospects more positively. Some prominent examples, taken from the largest holdings of the Vanguard Value Index Fund in early 2007, include Chevron, AT&T, Morgan Stanley, IBM and Eli Lilly. Identifying such companies can take a lot of analysis, based on many assumptions that might or might not prove out.

The Ultimate Buy-and-Hold Strategy uses a different approach, a purely mechanical one, to identify value companies. We start by identifying the largest 50 percent of stocks traded on the New York Stock Exchange and then including all other public companies of similar size. These companies are then sorted by the ratio of their price per share to their book value per share. The top 30 percent of this list, the companies with the highest price-to-book ratios, are classified as growth companies. The bottom 30 percent are classified as value companies.

Although the most popular stocks are growth stocks, much research shows that historically, unpopular (value) stocks outperform popular (growth) stocks. This is true of large-cap stocks and small-cap stocks, and itís true of international stocks as well. From 1927 through 2006, an index of large U.S. growth stocks produced an annualized return of 9.3 percent; large U.S. value stocks, by contrast, had a comparable return of 11.5 percent. Among small-cap stocks over the same period, growth stocks returned 9.3 percent, and value stocks returned 14.5 percent.

Therefore, we create Portfolio 5 by adding equal slices (each shown in the pie chart as 12 percent of the entire portfolio) of large-cap value and small-cap value. At this point, the equity side of the portfolio is divided equally five ways.

This boosts the portfolioís return to 12 percent at no increase in risk. And notice how much this adds to the 37-year cumulative return: $2.8 million. That is twice the ďadded valueĒ that came from Portfolio 4.

To recap where we are at this point, we started with a standard industry portfolio mix, refined the fixed-income portion and added real estate, small and value stocks to the equity portion. The result is an increase of about 15 percent in annualized return (and of more than 72 percent in cumulative return) at essentially the same level of risk.

Now there is one more very important step in creating the Ultimate Buy-and-Hold Strategy.


The final step toward Portfolio 6 is to go beyond the U.S. borders and invest in international stocks. U.S. and international stocks both go up and down, but often they do so at different times and different velocities. Because (to use a phrase from the experts) they are non-correlated, international stocks are slam-dunk diversifiers to reduce volatility.

Like U.S. stocks, international stocks have a long-term upward bias. Yet when their shorter-term movements offset each other, as they often do, the combination has a smoother long-term upward curve than either one by itself.

There are two major reasons international stocks are non-correlated with U.S. ones. First, they trade and operate in different markets. Second, currency fluctuations affect their prices when translated into U.S. dollars.

The virtues of small-cap stocks and value stocks apply equally to international stocks as to U.S. stocks. Portfolio 6 slices the equity portion equally 10 ways, adding international large, international large value, international small, international small value and emerging markets. We havenít discussed emerging markets, and this isnít the place for a full discussion, but let me say that emerging markets represent great long-term growth opportunities. Thatís why they deserve a place here.

As youíll see, the annualized return of Portfolio 6 jumps to 13.1 percent and the standard deviation falls to 10.9 percent. Cumulatively over 37 years, this portfolio produced a return of $9.6 million, nearly $5.8 million more than Portfolio 1. If you go back to my premise that you could implement this strategy in a total of 40 hours, the added-value return works out to $144,556 per hour for your time. (Too bad you canít do that for a whole career!)

This completes the basic makeup of the Ultimate Buy-and-Hold Strategy, which over this time period increased annualized return by 26 percent while reducing volatility by about 4 percent. This is not complicated, and itís based on solid research, not hocus-pocus. It doesnít require a guru. It doesnít require investors to figure out the economic landscape or make predictions about the future.

Let me say something about risk. While the standard deviation of Portfolio 6 fell by 4 percent, I think the real risk fell much further. Consider that Portfolio 1 contained only about 500 stocks. Thereís always a default risk when companies implode unexpectedly. (Enron is a recent example.) Now consider all the stocks held by all the funds in Portfolio 6. At the end of 2006, according to Dimensional Fund Advisors, those funds owned a total of 14,264 stocks. Even if you figure that some part of that number represents duplications, Portfolio 6 represents ownership in many thousands of stocks, not just 500. To my way of thinking, that much diversification is very worthwhile in terms of peace of mind.


The trickiest part of the Ultimate Buy-and-Hold Strategy is getting the level of risk right for each individual investor. The most important asset-class decision an investor makes is how much to have in fixed-income and how much in equities. In these illustrations we have used a 60/40 mix. That is an industry standard, and I believe that over a long period of time most investors can use it to accomplish their goals at very reasonable levels of risk.

But this may not be right for you. For help in applying risk-vs.-reward to your own situation, I suggest you read one of our most important articles, ďFine tuning your asset allocation .Ē

As I mentioned earlier, thereís no single mutual fund that puts all the pieces of this together under one roof. For help in finding funds, I recommend another article, ďThe best mutual funds: DFA or Vanguard ?Ē For an excellent discussion of the value of non-correlated assets, I recommend a fine article by my son, Jeff Merriman-Cohen, called ďThe perfect portfolio .Ē


This combination of asset classes works best in tax-sheltered accounts such as IRAs and company retirement plans. When you are using it in taxable accounts, we recommend that you leave out the REIT fund and divide that portion of the portfolio equally among the other four U.S. equity classes. I say this because real estate funds produce most of their total return in the form of income dividends, and those dividends may not qualify for the favorable tax treatment afforded to most other dividends.

Itís interesting to note that leaving REITs out of this portfolio would have reduced the 37-year annualized return by only 0.03 percent Ė a tiny difference that would not show up in our presentation because of rounding. We still believe REITs are valuable not only for their return but for their diversification.

Many people implement this strategy by using taxable accounts to supplement their employee retirement plans in order to capture asset classes not available in those plans. Investors who take this approach, which we favor, should hold REIT funds in their tax-sheltered accounts.


Even though this is the best buy-and-hold strategy that I know for serious long-term investors, it isnít flawless. Investment markets are not highly predictable, and this strategy might not work as well in the future as well as it did in the past.

The equity side of this portfolio is slightly overweighted to value stocks. Yet it is quite possible that value stocks will underperform growth stocks over the next five, 10, 15 or 20 years. The portfolio contains a large dose of small-cap stocks. But itís possible that large-cap stocks will do better than small ones in the future. This portfolio contains an above-average exposure to international stocks, which could underperform U.S. stocks in the future. Likewise, itís possible that fixed-income funds, which make up the minority of this portfolio, could do better than equities in the future.

All this uncertainty is simply inevitable. Still, I believe the Ultimate Buy-and-Hold Strategy deals very well with it. If you own this portfolio, you arenít dependent on any particular asset class. You have them all. And no matter which ones are doing well, you will own them.

To my mind, this is the best an investor can do. And when you have done your best, itís time to turn your attention to something else. A very good ďsomething elseĒ is to make sure you are living your life the way you want to.

Directors and officers of DFA Investment Dimensions Group Inc. include:
ē David G. Booth, co-founder, director, CEO, president and chief investment officer; trustee, University of Chicago
ē George M. Constantinides, Leo Melamed Professor of Finance, Graduate School of Business, University of Chicago
ē John P. Gould, Steven G. Rothmeier Distinguished Service Professor of Economics, Graduate School of Business, University of Chicago
ē Roger G. Ibbotson, Professor in the Practice of Finance, School of Management, Yale University
ē Robert C. Merton, Nobel laureate, John and Natty McArthur University Professor, Harvard University
ē Myron S. Scholes, Nobel laureate, Frank E. Buck Professor Emeritus of Finance and Law, Stanford University
ē Rex A. Sinquefield, co-founder and director; trustee, St. Louis University; life trustee, DePaul University
ē Abbie J. Smith, Boris and Irene Stern Professor of Accounting, Graduate School of Business, University of Chicago.

6,362 posts
msg #51576
Ignore TheRumpledOne
5/14/2007 4:06:20 AM


StockFetcher Forums · General Discussion · Article: The ultimate buy-and-hold strategy for Long-Term Investors<< >>Post Follow-up

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