A word to the wise: Ignore conventional wisdom

Proponents of conventional investment wisdom recommend that financial advisers create buy-and-hold asset allocation portfolios, focused on growth stocks, to obtain high returns over the long run, while ignoring short-term volatility and risk to capital.

This approach seemed to work when the greatest secular bull market in history hid its flaws in the 1980s and 1990s. But after huge losses last year, many investors are revolting.

The concept of buy-and-hold grew out of the belief that you can’t time the market.

Investors have accepted market volatility because stocks have been the only financial assets that provide a return that has outpaced inflation.

The problem is that investors don’t buy and hold, because the stock markets will always give them more risk than they can tolerate. Investors faced with 40% to 50% declines sell to conserve their remaining capital.

In theory, market returns will always bail you out, so investors shouldn’t worry about losses. The unfortunate truth is that if an investor loses enough capital, he or she may never recover.

The entire financial sector is under siege, and advisers need to recognize fully the serious flaws in these conventional approaches. The money management community has combined several different theories to justify ignoring short-term risks to capital.

First, modern portfolio theory suggests that a diversified portfolio will sufficiently limit risk to capital. Yet last year, we saw all asset classes fall hard, proving that diversification alone isn’t enough.

Second, conventional theory also suggests that asset allocation policy determines 90% or more of returns. This was an outgrowth of the approach taken by pension funds.

But the assumption that successful institutional investment strategies can be applied to individual investors is flawed.

Pension fund managers react differently to significant declines in account values because it isn’t their money. They also tie investment success to relative outperformance.

If they outperform their benchmark in a down market, by posting a 35% loss to the latter’s loss of 38%, they don’t lose their jobs.

Faced with the same declines, individuals will bail on their investment plan. When market cycles turn negative, investors compare their performance to what they could have obtained in a certificate of deposit.

Another flaw in the passive approach is that secular market trends last a lot longer than most people think. Our historical market research shows that positive and negative return cycles average 17 years in duration.

Most advisers know that stocks have provided investors with about a 10% rate of return over the past 100 years, but most don’t realize that 53% of the return has come from price appreciation and 47% from dividends. Dividends can provide a reliable source of cash flow that can be reinvested to promote compounding and dollar-cost averaging, or taken as income to support lifestyle.

During secular-bear-market cycles, it is dividends, not price appreciation, that provides investors with positive returns. Therefore, dividend-paying stocks, not growth stocks, should be the building blocks of the portfolio construction process.

A successful investment process must control risk to capital to allow investors to stay comfortably invested in both positive and negative market cycles.

New approaches should be active and responsive to changing market conditions. Portfolios should focus on value to identify opportunities to buy low.

Stocks should primarily be dividend payers to generate cash flow.

Risk management should be incorporated into the portfolio management process to attempt to control the loss of capital, especially in down market cycles.

Don Schreiber Jr. is president and chief executive of Little Silver, N.J.-based WBI Investments, which manages $300 million using a high-yield dividend-paying strategy.