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The Fatal Flaw in Most Financial Plans

The Fatal Flaw in Most Financial Plans

The following is a letter I wrote to the Certified Financial Planners Board of Standards, the College For Financial Planning, and the Financial Planners Association in late 2002. Its message is as relevant today as it was then.

To Whom This May Concern:

I believe very strongly that certain standards in the financial planning industry are promoting flawed financial plans. During the past two years, several million American investors have discovered that their financial plans are not working as hoped. The system we all have worked so hard on is obviously flawed when losses can be measured in trillions of dollars.

In reviewing many financial plans over the years, I believe I have found an omission in almost all plans that contributed to recent losses and subsequent disappointment for clients. I believe this common omission needs to be addressed in the financial planning process your organization promulgates. I appeal to you as a leader in the industry to reexamine the issue I am raising.

Our organization has developed a great reputation for integrity, and I am relying on this when I ask you to accept my comments constructively since that is how they are intended. Hopefully, an open review of these ideas will raise the standards of the entire industry, something we all strive for. A recent newspaper column written by one of the national brokerage firms caught my attention because it vigorously promoted buy-and-hold as the only effective way to invest. The article was well written but contained a serious error that amounts to a financially fatal flaw. Sadly, this flawed thinking has been repeated so often that it has become accepted as truth by millions of investors and, I am embarrassed to say, even by many financial planners.

By the 1990’s the financial planning tradition was well established. Planners and stockbrokers taught their clients the same things they had been taught. They encouraged clients to reduce risk by diversifying their investments among different asset classes such as stocks, bonds, and cash, as well as diversifying within those asset classes. We were trained to tell clients that “investing is a long term process” and that you should “buy-and-hold investments for the long run.” and “the markets always bounce back”. However, in reality, stock markets don’t always go up.

On December 31, 1964, the Dow Jones Industrial Average closed at 874.10. On December 31, 1981, it was 875.00. In 17 years, buy-and-hold investors basically broke even! A passive buy-and-hold clearly did not work well in that 17-year period.
Many financial advisors wrote financial plans for their clients based on assumptions that the stock market would continue to perform as it had performed in recent times. By largely ignoring the pre-1975 history of the stock market, they built financial plans on weak foundations and shifting sands. To me, it seemed inevitable that these plans would eventually lead to huge investor losses if the stock market went through another of these long correction periods.

In researching the stock market over the past 200 years, Robert Powers, Inc., found seven separate cycles of strong “bull phases” followed by weak “bear phases,” each side averaging about 14 years in length. (implying a 28-year average cycle) The average real return of the stock markets during the 104 years encompassing the seven bear phases was less than 1% per year. This knowledge of history leads to the understanding that the weakness in the stock market from 1964 to 1982 was not unusual, it was normal! Yet most plans ignore data from this period.

Bull phases in the stock market do have pullbacks, but the declines are relatively few and shallow. The two bear markets of the 1982-1999 bull cycle averaged less than 4 months in length; they were pretty much over before investors received their quarterly statements. Bear phases, however, are dominated by rolling bear markets. The 1966-1982 bear phase had four distinct bear markets. Just as investors recovered from one bear market, another would begin. The 1929-1948 bear phase had five distinct bear markets. It seems that about once each generation, investors get mauled by one bear market after another.

John Maynard Keynes, the foremost economist of the mid 20th century, when asked to discuss long-term investing said “In the long run we are all dead.” When market cycles are revealed to be not a tolerable three to five years as is widely quoted, but 25-30 years, Keynes’ quote has relevance to us all.

The research I have conducted on the stock market has shown me that the buy-and-hold philosophy of investing works fine—but only about half the time, during bull market phases. Buy-and-hold does not seem to work during bear market phases.

However, there are strategies that have worked during bear markets. I learned what strategies might work during bear markets by studying the greatest investors of our time, including Peter Lynch and Sir John Templeton. Each of these master investors thrived even during the 1966-1982 market weakness. How? By rapidly adapting to fundamental changes in the markets; in short, by using strategies other than buy-and-hold.

Peter Lynch is an excellent example. Lynch achieved his fame as one of the top mutual fund managers during the 1970s and 1980s. Although he is now a buy-and-hold advertising icon, as a fund manager, Lynch’s average holding period for a stock was less than eight months. Morningstar research data also show that during some years, Lynch’s average holding period for a stock was less than four months! Peter Lynch was a very active trader, who ruthlessly cut his losers and only held his long-term winners. Lynch rarely followed a buy-and-hold strategy as he was achieving international acclaim as one of the best investment managers of all time. Whether you call his system stock picking, stock market timing, or whatever, Peter Lynch’s performance record is among the best the world has ever seen.

Further study reveals that there are a number of other strategies that are much more effective than passive buy-and-hold. John Templeton’s main strategy was to “buy a good bargain and hold it until you find a better bargain”. Other strategies include sector rotation, money flows, style evolution, technical analysis, and contrarian investing. These are just a few examples of what my work calls adaptive strategies.

Knowing these research findings, do you see the fatal flaw in most financial plans? It’s a lack of diversification. Not merely the need to hold many stocks instead of just one that many stockbrokers talk about. The fatal flaw in most financial plans is the lack of diversification of investment strategies. Most financial plans written in the 1990s were based on only one investment strategy, passive buy-and-hold. My experience tells me that diversification among strategies is the method that most reliably leads to reduced risk, and often enhanced returns over a complete market cycle. A good financial plan should include diversification among strategies – including buy-and-hold – so the entire portfolio can adapt to changing markets™ when necessary. However, in all my training through the College for Financial Planning, IAFP Advanced Planning Conferences, and more, I don’t remember a serious discussion of any strategy other than buy-and-hold.

Buy-and-hold is attractive to many investors because it stands out as simple and easy to understand in an extraordinarily complex arena where much is unknowable. It is attractive to many planners because it is an easy concept to develop a small-business model for. Unfortunately, it provides no defense of client money during prolonged bear markets. A diverse mix of strategies, including both buy-and-hold as well as adaptive strategies™ are needed to be successful in both advancing and declining markets. Granted, this will add another layer of complexity to the financial planning process, since this approach can be more technical, time-intensive, and generally require a higher level of skill to execute. However, it is in rougher times that the skilled professional proves his or her worth.

If, as the historic data suggests, we may be in the beginning of a long bear market or even just a long flat market, investors and their advisors must explore investment strategies beyond buy-and-hold. I am not recommending that anyone completely abandon buy-and-hold because, in fact, it does work under certain market conditions. However, I do recommend that investors diversify their strategies just as they diversify their stocks and asset classes. Strategies adapted to specific changing markets reduce risk and outperform passive buy-and-hold.

I believe this added level of diversification needs to be included in the financial planning process, and I respectfully request that the various committees that address standards and curriculum look into this.

I look forward to hearing the discussion unfold.


William T. Hepburn