Advantages of a Buy and Hold Strategy

On 03/30/2011, in Investment Strategies, by Jordan Wilson
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There are advantages and disadvantages to the buy and hold investment strategy.

I will review both sides of the argument. Then you can decide for yourself if buy and hold is right for you.

Subsequently, I will outline some tweaks to the strategy that hopefully build on the buy and hold’s strengths and address its legitimate concerns.

Today we will review the benefits of buy and hold.  

I advocate essentially a buy and hold strategy for long-term investing.

But remember that I recommend passive investing. The objective is to create a well-diversified investment portfolio with the focus on cost minimization and matching market returns. Dollar cost averaging should generally be utilized and the investment horizon is typically long.

Because of this, I normally recommend investing in low-cost index funds, open ended mutual or exchange traded, for most long-term investors rather than individual stocks and bonds.

As we will see over the next few posts, buy and hold (with a few tweaks) should usually work well when investing in low-cost diversified funds.

If investing in individual assets that lack built in diversification (e.g., common shares of AT&T, Deutsche Bank, Cathay Pacific, etc.) and are subject to nonsystematic risks, the buy and hold strategy may not work as well. But that is not our focus at this time.

Okay, on to the perceived advantages of the buy and hold approach.

Easy To Understand and Implement

Buy and hold is an easy investment system to employ.

You identify strong assets with long-term growth potential, acquire them, and hold them throughout your investment horizon.

No need to constantly monitor and trade as the short-term trends and volatility dictate.

Consistent with Investment Theory

Conventional investment theory supports buy and hold investing.

Over the long run, higher risk assets will outperform lower risk assets, on average. And historical data shows this to be true.

Of course, at times one requires a very long time frame to see this out. It took 25 years for the Dow Jones Industrial Average to recover from its highs of 1929 and subsequent crashes. Had you been 30 or 40 years old and invested the bulk of your assets in the late 1920s, a buy and hold strategy would not have brought you success. So while it works in the long run, realize that long may not be 5 or even 10 years.

Less Emotion, More Discipline

Two things I like in investing. Keeping the emotions to a minimum and maintaining a disciplined investment approach.

Without worrying about short-term price fluctuations or general market volatility, a buy and hold strategy will help you stay the course.

And combined with dollar cost averaging, you may actually come out ahead by acquiring subsequent assets at sale prices.

Passive Investing Outperforms Active

We covered this issue previously in some detail.

How active management compares to passive investing.

The relatively few scenarios where active investing may be appropriate.

And why active investing tends not to outperform a passive approach over time.

The ability of even professional investors to time markets or consistently pick the best individual investments is doubtful.

Most of you reading this do not have the technical training, investment experience, analytical tools, access to information, nor the time to study investments that the professionals do. If they cannot outperform using an active approach, should you even want to try?

So do not worry about attempting to get in and out of investments to capitalize on price fluctuations. Instead, find quality assets and take a buy and hold approach.

Less Costly Than Active Trading

While transaction fees have fallen substantially over the years, there is usually some price paid when trading. The more you trade, the greater the costs. And the more you pay out in expenses, the less you keep in your own pocket or have to reinvest for compound growth.

A significant cost that many do not fully factor into their calculations is taxation.

Unless your money is sheltered in a tax exempt or tax deferred account, you will be responsible for taxes owing on any realized gains (and in some instances on unrealized profits). The more frequently you trade, the sooner you (hopefully) trigger capital gains, and the sooner you must pay the tax man. Once you have paid your taxes, that is less money that can compound on your behalf over time.

You are usually much better off delaying payment of tax as long as you can.

In general, I agree with these advantages.

At a more detailed level though, there are a few caveats to the buy and hold strategy.

Some of these caveats, and the need to tweak the traditional buy and hold system, is due to potential disadvantages.

Of these negatives, we will review next time.

 

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