Zerohedge reposted a short commentary by Mark Spitznagel from Universa Investments, the firm that Nassim Taleb is affiliated with. The short version is that buy and hold doesn’t work due to what he calls a volatility tax. Investors can’t capture the average return of the market due to the lumpiness of returns citing this example; “lose 50% one year, make 100% the next, and you’ve experienced an impressive average return of 25%, yet you just barely made it back to even.”

His framing of the return expectation seems to focus on the wrong thing. If you put every nickel into an index tracker and just hold it, your return will equal that index minus the expense ratio. If in a ten-year period the index you are tracking goes up 100% you’ll get 100% less a handful basis points compounded. In his example, I don’t think anyone would say the average return was 25% expecting to get that result. If their index of choice was exactly flat in a two-year period, I would think an investor would expect to be in line with the index, again save for the expense ratio of the fund.

The concept of a volatility tax is interesting though in a behavioral sense. You are no doubt familiar with the studies that show that actively managed funds collectively do worse than index funds and that fund investors’ actual returns are far worse than the funds they own? Here’s a recent update on Dalbar’s work on this.

The difference comes down to behavior. Investors make poor (emotional) decisions like selling at the wrong time and buying at the wrong time and suffer for it. One trigger for these poor decisions is the bad kind of volatility (the volatility that sends markets lower). In the middle of the early February panic I called it out as merely a panic and noted that like many of these events it was likely to be quickly forgotten. Obviously, someone was selling at the lows on February 9th and while some of the sellers were traders who quickly got in, some weren’t and now the market is up 9.5% from the intraday low through last Friday. Anyone selling at the low in a panic, paid a volatility tax.

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