Stocks or bonds? Capital gains or dividends? Momentum or value? Obviously, most investment decisions mean trade-offs. But historically,few trade-offs have proven as important as the one between risk and reward.

It seems simple enough. After all, higher risk usually seems to go hand-in-hand with greater potential gains.But is that always the case? And how does an investor weigh that critical trade-off in formulating a long-term investment strategy?

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Initially, most novice investors unknowingly adopt a“seat-of-the-pants” strategy. They may act on a hot tip,a magazine write-up, or a recommendation from a friend. But in general, they’re most anxious to buy after stocks have already risen substantially, and when the economic outlook appears rosiest. Such stocks or mutual funds purchased late in the economic cycle may rise in price for a period of time. However, when investors lack any personal guidelines on when to sell,these investments are often later dumped at a loss in a fit of frustration – usually at the depths of a bear market.

Developing an investment strategy requires both time and patience. And strategies are as varied as the millions of investors out there. Realistically, there is no single best strategy for everyone, and no single strategy that works best in all markets. In other words, here too is a trade-off.

At any point in time, one particular strategy may shine far brighter than another. For example, in the 1930’s or during the 10-year period from 1965 through 1974, the only investors who outperformed cash were those who utilized some type of market timing or portfolio allocation.By the time the depths of the 1974 bear market rolled around, the words “Buy-and-Hold” were among the most scorned and contemptible words on Wall Street.

Yet today, 25 years later and after the longest period in history without a 20% decline in both the DJIA and the S&P 500, it is ironic that this same “Buy-and-Hold”strategy is widely touted as the only reasonable approach to investing.

“Those who do not learn from the past, are doomed to repeat it.” – George Santayana

History is an invaluable guide to weighing such diverse investment strategies. Only by examining the strengths and weaknesses of each approach can an investor truly understand these trade-offs. And in the end, the objective of each investor should be to adopt a strategy with which they feel comfortable. More importantly, the strategy must be one to which an investor can adhere through the enthusiastic profits of bull markets AND the devastation of bear markets.

“BUY – and – HOLD”Only after a multi-year bull market…

Buy-and-hold implies staying almost 100% invested at all times. For that reason, in charging long-term bull markets, few strategies will match the return of a buy and-hold approach. That’s the simple basis for this strategy becoming the “darling” of Wall Street after every long-term, multi-year bull market. Likewise, as the stock market is hitting record highs, it’s not uncommon to see brokerage firms or mutual funds releasing new studies in an attempt to validate this method.

However, it’s important not to confuse buy-and-hold with dollar-cost-averaging where an investor sets aside a certain dollar amount every month or quarter with which to purchase stocks. Dollar-cost-averaging has the distinct advantage of purchasing more stocks or“value” when the market has recently suffered a bear market decline. In addition, dollar-cost-averaging adds discipline… something new savers or investors often lack.

But to dollar-cost-average does not mean an investor must remain 100% invested day-in and day-out. Those new funds, set aside each month or quarter, can be even more effective at purchasing stocks at a lower average cost when used with other strategies designed to avoid bear markets.

Surprisingly, most “buy-and-hold” studies actually turn out to be endorsements for dollar-cost-averaging.Take this widely publicized report from the American Funds Group:

It shows that someone,who invested $5,000 in the S&P 500 Index at the stock market’s peak each year over are cent 20 year period,would still accumulate$510,905 by the end of 1995. It’s obvious that a market peak is the worst time to buy stocks. Therefore, the study concludes, a buy-and-hold strategy is superior. But is it?

If you simply back up that study 20 years so that it ends in 1975,the results are dramatically different. In fact,the total return after 20 years would barely have matched the profits of a timid saver who put his annual$5,000 into a 4%money market fund.Imagine… investing religiously for 20 years and not even beating the return of a money market fund.
Trade-Offs - 1

Imagine… investing religiously for 20 years and not even beating the return of a money market fund.

What gives? First, this study is really about dollar-cost-averaging since the portfolio starts with nothing and adds $5,000 every year. Second, the study was conducted over a 20-year period that is hardly representative of stock market profits. It was started at a time when the S&P 500 Price/Dividend Ratio showed stock values to be near the “cheapest” bargain prices of the past half century. And the study ended with market averages at record highs, and that same P/D Ratio showing stocks at their most overvalued, expensive level in history!
Trade-Offs - 2


The case for a buy-and-hold strategy rests heavily on fundamental factors. For example, on average,the stock market goes up in 3 out of 4 years. Or historically, the S&P 500 Index has averaged a+10.8% annual return (including dividends). So hypothetically, an investor who buys a stock or mutual fund merely has to hold on long enough for their holdings to turn a profit.

Investors also find comfort in the fact that most bear markets hit blue chip averages for only a 20-30% loss.And riding through even a 30% loss doesn’t sound too severe to an investor who thinks that his stock or fund may recover within 18 months.

Finally, there’s always the argument that if you only pick good stocks with consistently rising revenues,then your portfolio won’t get hit too hard in a bear market. Or if you stick with only top-performing mutual funds, the managers should do a decent job of reducing risk so your fund doesn’t tumble as far in a major bear market.


‘NO! NEVER AGAIN!’ exclaimed the widow from a small city near Portland, Ore. ‘When I bought my mutual funds I paid three times what they’re worth today. It would take me 20 years to break even.’” – FORBES, August 15, 1974

The evidence against a blind buy-and-hold strategy,especially for someone in or nearing retirement, is compelling… but buried in historical archives. The reason is apparent from this table:

During the past 24 years, there have been only two bear markets in which the S&P 500 Index lost over 20%. There have been no large bear markets and not a single painful bear market that required many years to recover. Yet historically…

  • Bear markets have struck about once every 3-4 years.
  • Large bear markets (>35% loss in S&P 500 Index)have appeared about once a decade.
  • Painful bear markets (requiring over 3 years just to recoup losses) have also hit about once a decade.

But the mere fact that stocks are richly priced or that we may be overdue for a big bear market is only the first question facing a buy-and-hold advocate. Here are the strongest arguments against blindly following a 100%buy-and-hold philosophy in today’s market:

1. “Recession-Proof” is a figment of Wall Street’s imagination.

In a major bear market like 1973-74, even industries that are supposedly “safer” can get knocked into a tailspin with devastating results:

And even if one could foretell which stocks would see rising revenues during a major bear market (like 1973-74), it’s no guarantee that your portfolio won’t suffer:
recession - 2

2. “Fund” is not synonymous with “Safety.”

Here is what the August 1974 Forbes article [quoted earlier]had to say about mutual funds after the 1973-74 bear market:

“Talk with these people at any length and you quickly understand why they are more sour on mutual funds than on stocks. They always knew stocks were a gamble. But they thought of mutual funds as ‘an investment.’… The point is that they thought mutual funds were for safety. Or so they thought.”

This message is more striking when stepping back to the previous bear market of 1969-70. Here is how the top 6 funds of 1968 fared:

You might ask why 5 of these funds no longer exist today. Quite simply,because their share holders were so devastated by the bear markets of 1969 (and later 1974) that the funds had to be liquidated, sold out,or merged. Within the fund industry, it’s called “survivorship bias.” And it’s the reason you see only top-notch track records of funds that have existed over the past quarter century. Other sour track records have been conveniently wiped out – along with the poor performing funds.
top 6 funds

3. Riding through a bear market often means waiting many years to recoup one’s losses.

Recent bear markets, particularly the 1990 Bear and 1987 Crash,have created a distorted view of bear market risk:
DJIA Index

These recent bear markets have been the shortest in history, and among the easiest from which to recover.In this century, excluding the 1929 Crash…

  • Bear markets average almost 1 1/2 years in length.
  • Bear markets average a -32% loss in blue chip indexes.
  • Once started, bear markets average over 2 1/2 years to recover.

But often, the real question facing investors is not how long it takes to recoup one’s losses – but how soon your portfolio can get back to where it would have been if sitting in cash. In such real dollar terms, it’s not uncommon to require a decade or more to recover from a bear market, particularly a bear like 1929, 1969, or 1973 that strikes when the Price/Dividend Ratio shows stocks are richly overpriced.

4. In a bear market, an investor’s portfolio loss usually far exceeds the drop in the blue chip DJIA or S&P 500 Index.

One reason is that these averages are price and capitalization weighted, respectively. In other words, they give far greater weight to high priced stocks and large-cap companies.

But few investors or mutual funds allocate their portfolios in such a manner. If you (or a fund manager) divides your portfolio somewhat evenly among a number of stocks, then an unweighted index, like the Value Line Index of 1700 stocks, is more representative of your potential risk. In the bigger bear markets of 1969 and 1973, the Value Line lost over 50% before hitting bottom.

5. Even the most dedicated buy-and-hold strategies usually turn into cut-and-run at the worst possible time.

To the novice investor, riding through even a big bear market appears fairly easy. After all, it only requires discipline. The problem is that by the time your portfolio has lost 1/3 to 1/2 its value,you’ll start reading headlines like these that appeared at the very bottom of the 1973-74 bear:

Bear markets start with low inflation, rosy interest rate forecasts, and what appears to be clear sailing weather for the economy. They end in the depths of recession and fearful despair that the worst is yet to come. In reality, few investors are able to ride past headlines like the above without “cashing out”at big losses.


The most misunderstood objective…

Many critics argue that market timing can’t beat the long-term +10.8% return of the S&P 500 Index. That may or may not be true, depending on the timing model or strategy used. But “beating the market” isn’t always the primary objective of market timing. For many, it’s“risk management.”

Riding through a major bear market and losing over 1/2of one’s portfolio (measured by the Value Line Index)can be devastating – financially and emotionally. In fact, after truly big bear markets, many investors will not return to stocks or mutual funds for many years:


“When investors do turn toward stocks, they are likely to be much more selective than they have been. The change in investment strategy is already evident. And, like the bear market of 1962 which wiped out the speculative fever for nearly five years, it may be years before investors feel chancy again… Says John Rogers of Chicago’s A.G. Becker& Co., ‘I don’t think the small investor will be back for three or four years.’”– BUSINESS WEEK, May 23, 1970

What’s more, for an individual nearing retirement, a major bear market could mean a dramatic change in lifestyle or even cancellation of retirement plans. In a bear market like 1973 or 1969 [quoted above], risk management means more than preserving capital… it means safe survival.

Don’t confuse timing with forecasting. No one can forecast the stock market or predict the high/low/close for the DJIA over the next year.Market timing uses a predetermined set of criteria or indicators as a trigger for moving one’s portfolio into or out of the stock market.

Such a strategy may involve any thing from a complex econometric model to a simple moving average. But in general, most market timing strategies involve stepping 100% into stocks or 100% into the safety of sidelines cash.


The advantages of market timing, if successful, are readily apparent. It has the potential for increasing total returns while reducing risk. For example, let’s look at a simplistic 150-day moving average as a timing tool for investing in the S&P 500 Index.

During the 40 years ending in 1995, assume an investor moved his portfolio into T-bills whenever this S&P 500 Index fell below its 150-day moving average. Such a market timing strategy could have nearly doubled one’s total return. A single $10,000 investment in 1956 would have grown to $1,157,456 over the period… instead of the $587,664 with a buy-and-hold strategy.

However, the real benefit of such a simple market timing strategy may not be the higher profits, but the reduced risk. Over that 40-year period, a buy-and-hold advocate would have suffered through seven bear market declines of -20% or more. Meanwhile, the individual using the 150-day moving average would have a worst-case portfolio loss of -15% on just one occasion. Yet over that 40-year period, this market timing strategy never forecast the stock market and never caught the exact peaks or bottoms in the market.It merely introduced “risk management.”


The debate about market timing often centers on its ability to forecast stock prices or outperform the market.If one accepts the fact that market timing’s primary objective is to manage risk, these emerge as the strongest arguments against a market timing strategy:

  1. It’s easy to mix “market timing” with emotions.For example, one might think that watching for an imminent recession would be a valuable signal to exit stocks. However, by the time each of the past 4 recessions was first recognized by media headlines, the stock market had already suffered over 70% of its bear market losses.
  2. Some market timing systems, particularly moving averages, can trigger false signals. Any investor who has ridden through 3 or 4 consecutive whipsaws(with accompanying commissions) may start to deviate from this strategy… just when it’s needed most.
  3. By definition, virtually any market timing strategy will under perform buy-and-hold during a long-term bull market. In other words, during an extended bull market with few corrections, a 100% fully invested position is obviously the most profitable. But it’s during bear markets that a mechanical market timing method always shines, often saving losses that more than offset any profits that were temporarily left on the bull market table.
  4. Emotionally, market timing can be a difficult strategy to follow since, to be successful, it requires moving against the crowd. That’s particularly true in an aging bull market when economic forecasts are rosiest and fellow investors are most enthusiastic and confident.


The strategy utilized

Although it employs many of the same tools,a “risk allocation” strategy is not the same as market timing. Like market timing, it uses cash as a temporary parking place for investment capital. Unlike market timing, however, portfolio allocation is usually changed gradually as the level of risk shifts along with the weight of monetary and technical evidence.

Quite simply, charging bull markets usually have common characteristics. These often include a favorable monetary climate, falling inflation pressures, broad participation or breadth, and strong internal leadership. The more of these bull market characteristics which are present, the more aggressive a portfolio allocation one should employ.

For example, during the 35 years from 1961 to 1995, stock market gains averaged +15.9% annually when Spot Raw Material Prices were steady or rising at a very slow (<5%) rate. Conversely, the return from stocks didn’t match that of a money market fund once Raw Material Prices started rising at over a 5% rate. Similar risk trade-offs are available from historical analysis of factory Capacity Utilization and the Federal Reserve’s Discount Rate:
S&P500 - 2
S&P500 - 3
S&P500 - 4

The real value for long-term investors, comes from major models. Such indicators could be used individually as a timing model to determine when to be 100% invested or 100% in cash.Using the MEP in such a manner with the OTC NASDAQ Index would have multiplied an investor’s profits by 7-fold since 1968.

Other factors, too, need to be considered when allocating a portfolio based on risk. With the most reliable valuation gauge (the S&P 500 Price/Dividend Ratio) at an extreme 73 today, one should take note that stock market potential profits often drop dramatically. In addition, bear markets are usually more severe:
stock market - 1

It’s also valuable to note that the majority of profits are made early in a bull market. In fact, as shown in the graph below, in 6 of the past 8 economic cycles, over 75% of the bull market profits were made by the midpoint of the recovery. That becomes an important trade-off for investors in the 4th or 5th year of an aging economic recovery, when Wall Street analysts start to tout that the “big” profits still lie ahead.
S&P500 - 5

Quite simply, by basing decisions on factors such as Stock Market Potential as the S&P 500 Price/Dividend Ratio increases, potential gains in the stock market fall dramatically.P/D Ratio < 15 +19.9% annual gain P/D Ratio < 20 +11.7% annual gain P/D Ratio > 30 +2.4% annual gain P/D Ratio > 35 +4.7% annual gain Data compiled over 69 years.these, a risk allocation strategy will have an investor’s portfolio in a more defensive, higher-cash position when market risk is highest.


While many of the arguments for (or against) a “risk allocation” strategy appear to be the same as for market timing, there are critical differences. The first is that risk allocation is based on a gradual “weight-of evidence”approach. Consequently, this presents a mechanical method to control both emotions and risk.

Another major advantage to this strategy is that any mistakes are usually made on the side of excess caution.That importance of managing risk grows with portfolio size, and as an investor approaches retirement. For example, this figure shows what can happen to an investor when a major bear market strikes in the first versus the last year of a twenty year investment plan.Even dollar-cost-averaging can’t protect a retirement nest egg if a 1973-style bear market (-44.6% loss in the S&P 500 Index) hits just before it’s scheduled to hatch.
bear market

One time-tested truism on Wall Street is that the key to big profits is to never suffer any big losses. And for someone nearing retirement, it’s invaluable to remember that investment opportunities always come around again… lost capital does not.


  1. Of course there are no guarantees that risk allocation can avoid or sidestep every bear market.That’s true even with the best time-proven models and indicators.
  2. A risk allocation strategy requires both patience and discipline. As mentioned, any mistakes with this strategy usually come from sitting out of a rally in an aging bull market… something that few novice investors are willing to do – particularly when surrounded by crowd psychology.


No 100% correct answer…

There are trade-offs to every investment strategy. Some strategies (i.e., buy-and-hold)are much more enticing and easier to adhere to in a rising stock market. Other strategies(i.e., risk allocation) have the advantage of greatly reducing downside risk for an established portfolio. But every strategy has its weaknesses or perceived flaws – which opponents waste no time in embellishing.

For example, one favorite tactic of buy-and-hold advocates is to argue that the real risk lies in trying to “time” the market. Their studies, they argue, show that missing out on just the 40 biggest daily gains in the DJIA since 1980 would have eliminated 4/5th’s of the potential buy-and-hold profits.

Yet proponents of market timing, could also reasonably argue that if one successfully sidestepped the 40 worst daily losses in the DJIA since 1980, the percentage profit would have been 5,242% higher or a 6-fold gain over a buy-and-hold. In the end, such arguments based on number games are simply that… games.They should have little relevance in the decision an investor must make in selecting an appropriate strategy.Among the key questions you face, as an investor, are the following:

  • Am I building a new portfolio, and do I have at least 20 years until retirement?
  • l Can I afford to lose up to 1/2 of my portfolio or more if a major bear market like 1973 or 1969 strikes?
  • l Am I prepared to wait 4 to 6 years, or perhaps longer, to recoup the losses from a major bear market?
  • l Do I know, as a seasoned investor with experience in the deep recessions of 1970, 1974, or 1982, that I will not bail out in the depths of the next bear market when the economic/investment outlook is gloomiest and there’s no market bottom in sight?

If you answered “yes” to most or all of these questions,then a buy-and-hold strategy may indeed prove most comfortable. But if not, one should closely examine other alternative strategies. It might be reasonable to say that there’ll never be another 1929. But to believe that the past 20 years are proof that big bear markets are a thing of the past would be foolish, if not financially suicidal.

Today’s record Price/Dividend Ratio means stocks are more overvalued than they’ve been at any historic market top. And the public, infatuated with mutual funds, has committed a record percentage of their financial assets to stocks:
stock market - 2

These characteristics, along with the mutual fund frenzy and rose-colored inflation/interest rate forecasts haven’t existed since the late 1960’s. The odds are high, if not overwhelming, that a mega-bear market like 1969-70 or 1973-74 will strike within the next few years.

A good strategy should always be focused on risk management. The reason is simple – it is a“safety-first” strategy. By allocating our portfolio based on the degree of risk, we are (by definition)heavily invested in the earliest stages of a bull market.As technical and/or monetary warning flags appear,we shift an increasing amount of our capital in to defensive investments… including cash.

How has such a strategy worked in the real world? A recent article in Medical Economics by a leading tracking service identified only 6 financial newsletters that had beaten the Dow on a risk-adjusted basis since their inception (that is, provided a higher return for the degree of risk taken). Perhaps most importantly, this was accomplished without suffering a 10% decline over any time period– including the 1990 bear market and the 1987 Crash.That’s one reason why Forbes has described our strategy as “more or less impervious to declines.”

In our ongoing commitment to subscribers, we are constantly evaluating new tools and models to measure risk and determine when to be aggressively invested.We will always try to improve investment returns,while not repeating mistakes of the past. However, you will never see us sacrifice our objective, safety-first strategy for the sake of quick profits or the comfort of merely being a part of the Wall Street crowd. Our deep respect for historical risk comes from the time-proven lesson that profit opportunities always come around again… lost capital in a bear market does not.