How to Make Money in a Sideways Market

It might not be dead but buy-and-hold sure looks like it's gravely wounded. That passive, cheap investment strategy has a lot going for it, but today's bear market, which looks like it could move sideways at best if we're lucky, requires more flexibility and activity on the part of investors.

Here we are just three weeks removed from the worst October for the Dow Jones Industrial Average since 1987 and November is on track to be even grimmer. The blue-chip index penetrated the key psychological barrier of 8,000 and is trading at levels not seen in nearly six years.

It gets worse. The broader S&P 500 index, the real proxy for "the market," has blown through 800, a depth it hasn't plumbed in more than a decade. The Nasdaq Composite index, as we noted recently, has likewise been a sinkhole. Pull up a three-, five- or 10-year chart on any of those major indexes and it'll make a lot of buy-and-hold investors feel like chumps.

"Buy-and-hold is great if you can wait 30, 40, 50 years to climb back," says Kenny Landgraf, president of Kenjol Capital Management and an active investment manager. "But older investors don't have that much time, and the younger generation that can wait that long doesn't have any money."

Buy-and-hold works very well when the economy is clicking along like in the Goldilocks '90s, says Landgraf. The problem is that you can never abandon that strategy. It affords no way to play defense and preserve capital.

Fortunately, there are a few simple moves investors can make to offset some of the limitations of buy-and-hold. Joe Barrato, chief executive and director of investment strategies at Arrow Funds, believes every portfolio should have a buy-and-hold component at its core. However, there should also be components dedicated to areas such as alternative investments, commodities, REITs and gold. "Your allocation to those other components needs to be greater when we are in a secular bear market like we are now," he says.

In addition to diversifying like they have never diversified before, investors should be mindful of trading strategies that work better in a sideways market. Reversion to the mean, which says that stock prices eventually move back to their historical average, is one of the better ones. Common Sense columnist James B. Stewart, employs such a strategy, selectively selling when the Nasdaq climbs 25% and buying when it drops 10%. In another example, Jack Ablin, U.S. portfolio strategist at Harris Private Bank/BMO Capital Markets, says buy when the S&P 500 moves 5% above its 200-day moving average and hold until it breaks 5% below its 200-day moving average. (See chart below.)

The catch is that mean reversion, like other strategies, such as going both long and short, requires more work, more trading, more fees and -- especially with short positions -- more risk if you mess up. In other words, you may not want to try all of this at home, cautions Will Hepburn, founder and president of Hepburn Capital Management.

"Just because I go to Sears and buy a bunch of tools doesn't make me a mechanic," Hepburn says. "Long-short, mean reversion or sector rotation; the science is understanding those strategies. Knowing when to employ them is an art."

Which brings us to the advantages of a little active management. As a passive long-term investor, let's assume you have neither the time nor inclination to become an investing artist or scientist. Instead, consider rebalancing away from index funds toward those with long track records of solid active management through both good times and bad. After all, plenty of pros are surveying the charred market landscape and seeing that opportunities abound.

The fact that so many investors, market watchers and pundits are proclaiming the death of buy-and-hold might be the best contrarian indicator that it's alive and kicking. But we wouldn't bet on that. Just as when the Dow first fell through 10,000, bear-market rules apply: Preserve capital, take profits where you can and don't look down on cash.