Buy, hold vs. market timing

You may be a buy-and-hold investor or a market timer. How did you feel about the sharp decline in silver ETF prices after they touched an all-time high? Did you regret not taking profit at higher levels? Or did you take profit only to see prices move up further? Let discuss trade-off between strategy of buy-and-hold and market timing.

The trade-off

Take an investment of ₹50,000. Its value slips by 20% in a year and rises by 20% the following year. The investment value at the end of the first year will be ₹40,000 and at the end of the second year it will be ₹48,000 resulting in a geometric return of -2.02%. However, the arithmetic return of zero (average of -20% and + 20%) suggests investment value was unchanged. Clearly, it is not the case. The geometric return is lower than the arithmetic return because of volatility. Interestingly, this difference in return is referred to as volatility drag. Note, a buy-and-hold strategy will generate lower returns in volatile markets — higher the volatility, greater the drag. This drag is approximately one-half of the variance of the returns.

Market timing

The other side to buy-and-hold strategy is market timing. Empirical evidence suggests that individuals are typically not good market timers.

Research shows the buy-and-hold returns on investments are significantly higher than the actual returns of a market timer.

This difference is referred to as behaviour gap. It is attributed to error in human judgment — buying when prices rise sharply and selling in panic when prices fall.

How should you balance the volatility drag and the behaviour gap?

Conclusion

You should have pre-determined rules to take profit. For goal-based portfolios, this could be based on the required return you must earn to achieve your goal. Suppose the required return on your equity investments is 12%and the actual return is, say, 14%. You could keep 12% in the portfolio and take out the two percentage points of additional gains.

For trading portfolio, the rule for taking profit can be pre-determined based on price targets or based on continual reading of the charts.

Note, the rule for the trading portfolio moderates volatility drag but forces you to manage future regret (potential behaviour gap) should the prices go up further after you take profit.

(The author offers training programs for individuals to manage their personal investments)