Research Brief

Rethinking Buy-and-Hold Investing

The case for using rising market volatility as a signal to pare back on stocks — does higher risk always mean higher return?

One of the basic tenets of successful stock investing is that market volatility should be embraced rather than feared. In other words, when the market suffers wild swings, investors should look for opportunities to get in rather than bail out. It’s a pillar of the buy-and-hold school.

That makes the University of Rochester – Simon Business School’s Alan Moreira and UCLA Anderson’s Tyler Muir seem like a couple of flamethrowers. After studying U.S. market gyrations and returns from 1926 to 2015, the two have concluded that the right move amid a steep jump in stock volatility is the opposite of the standard advice: Investors should sell equities to substantially reduce their level of risk-taking, not pile on more risk.

In a paper published in the Journal of Financial Economics, the authors say long-term investors essentially give up 2.4 percent of their equity wealth per year by ignoring volatility instead of investing around it. That’s a hefty annual tax on a nest egg.

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So how does an investor gauge volatility? In their back-testing stock returns to 1926, Moreira and Muir tracked “realized volatility,” the measure of average daily stock price changes whether they grew larger or smaller each month. But in an interview, Muir said investors could simply use the VIX index, which has been Wall Street’s go-to volatility yardstick for more than 20 years. (Type “VIX” into any online quote charting service, like any other stock ticker symbol.) The index measures investors’ collective near-term expected market volatility by tracking real-time price changes in options contracts on the S&P 500 index. The options are a form of insurance — if the VIX rises, it means investors are buying more insurance against a falling market.

The VIX “works as well as realized volatility, and it is easy; anyone can look it up on any given day,” Muir said. For simplicity’s sake he envisions investors timing volatility by using a low-cost S&P 500 index mutual fund or exchange-traded fund. And, ideally, the fund would be inside a tax-sheltered account to avoid the tax implications of trading.

^VIX data by YCharts

U.S. market volatility all but dried up in 2016 and 2017, as seen above in a 10-year chart comparing the VIX to the S&P 500, as share prices overall climbed steadily higher. Indeed, the VIX index hit a record low in 2017. But it was too good to last: Stocks slid early in 2018, zoomed to new highs in the summer, plunged again in the fourth quarter, and now face new uncertainties about corporate earnings growth, interest rates and economic growth in 2019.

Historically, the argument against trying to time market volatility was straightforward. As Moreira and Muir write, investors were advised that “since volatility is typically associated with market downturns, and downturns are attractive buying opportunities for those with long horizons, it is not wise to sell when volatility spikes.”

Underlying that reasoning is the assumption that stock returns over time will gravitate toward the historical average annual total return of about 10 percent on the S&P 500 index. So the case for holding through volatile times is that “an increase in volatility makes stock prices more uncertain tomorrow, but not more uncertain over the long horizons that [buy-and-hold] investors care about,” the authors write.

But Moreira and Muir’s study of market patterns over the last 90 years led them to a different conclusion: A significant jump in volatility should be viewed as a warning signal to begin pulling back from stocks because the risk of being in the market is rising.

As an example, stocks began to suffer convulsive moves in September 2008 as the financial crisis deepened. Yet the market overall was relatively slow to react to the unraveling of the banking system. The Dow Jones industrial average was at 9,300 in early November 2008, as volatility gauges were flashing red. From there, the Dow would fall 31 percent to its ultimate low of 6,447 in March 2009.

Moreira and Muir see volatility-timing as a way to avoid the worst of market declines and preserve capital for reentering the market at lower prices when things inevitably calm down. “Investors can avoid the short-term increase in volatility by first reducing their exposure to equities when volatility initially increases, and capture the increase in expected [future] returns by coming back to the market as volatility comes down,” they write.

In part, their assumption is that stock bargains that emerge as prices fall won’t quickly reverse after a market slump, giving investors a substantial window of time in which to reinvest. “Valuation ratios [of stocks] will remain attractive for an extended period of time, while volatility is shorter-lived,” the study says. “A long-term investor can exploit this large difference.”

But as with any market trading program, the devil is in the details. One look at a VIX chart over almost any period shows how the index can quickly spike. The historical average VIX index reading is about 20. If an investor used that as a baseline, and the VIX began to rise, stock holdings would be reduced proportionally. So if the VIX suddenly doubled to 40, Moreira and Muir’s timing system would call for reducing stock holdings by 50 percent, shifting the sale proceeds to a cash account.

If the VIX then dived back to 20, the investor would be expected to move that cash fully back into the stock fund. “It’s important to get back quickly as volatility subsides to normal levels,” Muir said. “The strategy must be followed closely. If the average person gets out and is too scared to get back in, then they would not necessarily benefit.” He concedes that “this makes us cautious on interpretation of our results for the average person.”

Practically speaking, then, for many investors, tracking changes in market volatility may just be useful as a tool to aid better investing decisions. For portfolio managers accustomed to monitoring — and acting on — a wide range of market signals, the research could suggest consideration of a more active hand during periods of volatility.

“One thing to highlight, from our perspective, is not just about advice for the average investor, but in terms of thinking about risk and return in general,” Muir said. “In all of our economic models more risk goes with more return. For example, stocks on average do better than cash but they are also much more volatile.

“We find higher risk does not go with higher return,” he said. The research demonstrates instead that returns are higher as risk is reduced by evading high volatility. “So it means a rethinking of some of our models. We think of it as shedding light on the puzzle of risk and return.”

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About the Research

Moreira, A., & Muir, T. (in press). Should long-term investors time volatility? Journal of Financial Economics. doi: 10.1016/j.jfineco.2018.09.011

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