The Advice Remains the Same: Defensive Strategies Won't Protect You

Last Updated Apr 15, 2009 7:28 PM EDT

(Note: This item is part three of a series on why you shouldn't alter your investment strategy during booms or busts. For other posts in the series, see the links at the bottom of this item.)
If the perception of risks are high, which they are during bear markets, so must be the expected return. And the historical evidence is that investors persistently demonstrate a pattern of buying high and selling low when acting on their own. This destructive behavior is evidenced by the fact that investors typically underperform the very mutual funds in which they invest.

"Defensive" strategies
Investing history is filled with examples of strategies that try to benefit from observable patterns of past market performance. Unfortunately, the realized returns haven't matched the promise.

In their article "Noisy Signals: A Challenge to Tactical Strategies," Joseph Davis and Christopher Philips of Vanguard examined the performance of several different signals based on "conventional wisdom" to see if they actually translated into better risk-adjusted returns.

For example, they examined selling in the presence of an inverted yield curve (short-term interest rates exceeding long-term rates), which is a well-documented leading indicator of recessions. Vanguard found that the yield curve signal is "noisy." For the period 1952 through 2006, the yield curve inverted 19 times, but the U.S. economy lapsed into recession only nine times.

While the historical record shows that various sectors tend to outperform during tough times, Vanguard reached the conclusion that, "Even the most reliable indicators have low predictive power when used to execute real-time strategies. Investors seeking to mitigate equity market risks are better served with a strategic allocation to fixed income investments."

Noted author Peter Bernstein provided this insight: "Even the most brilliant of mathematical geniuses will never be able to tell us what the future holds. In the end, what matters is the quality of our decisions in the face of uncertainty." Thus, my advice will continue to be the same, unless compelling evidence, published in peer reviewed academic journals, demonstrates that there is a superior alternative strategy. Until then, my advice remains: buy, hold, rebalance and stay the course.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.