A long-term buy and hold strategy can work with individual, non-diversified assets. For example, shares of Cisco or Swiss Re. Or General Electric Capital bonds. Or the Japanese Yen.
But I would not recommend it.
Here is why.
Quality Can Change Over Time
If you find a solid company (or other non-diversified asset) with strong management and excellent long-term prospects, you can buy and hold individual assets.
However, few companies have been great investments over the very long term.
Yes, there are some, but will you be able to identify them? That is the question. At one point in time, Nortel, Bre-X, Enron, and General Motors were considered fantastic long-term plays. Industries and companies are not static. Good companies can fall and new companies can rise.
If you invest in individual companies, I suggest you spend more energy monitoring their performance and prospects. A rule of thumb should be that the greater the risk of the asset (i.e., the standard deviation), the more frequent the monitoring.
Systematic Versus Nonsystematic Risk
That is the difficulty with investing in assets which have nonsystematic risk components. Individual risk factors can significantly impact the fortunes of non-diversified assets.
Individual companies may face risks from management, operations, and competitors. They may also incur risk through key customers, suppliers, debt defaults, and legal problems.
Problems in any one of these areas may alter the future fortunes of a company and its stock.
That is the whole purpose of portfolio diversification. To spread out the investment specific risks amongst a variety of assets – preferably with low or negative correlations to each other – such that the nonsystematic risk level is minimized.
The goal is to eliminate all asset specific risks, so that only the systematic risk remains.
If you can achieve this, your portfolio will be more efficient, and likely more effective, than one that still contains nonsystematic risk components.
A Diversified Portfolio is Better
That is why I believe that a buy and hold strategy should be used primarily with diversified portfolios as opposed to single assets.
The concern over individual risks is minimized throughout the portfolio. One company may be devastated by a lawsuit, new competitor, patent expiration, departure of senior management, etc., but the impact on the entire portfolio from one of these events is small.
To some extent, this risk also exists in mutual, or exchange traded, funds.
The less the number of index components or the more that market capitalization is reflected in an index, the greater the probability that one company’s problems will impact the entire index. For a good example, google Nortel and its impact on the TSE 300 Composite Index.
While something to be careful of when investing, usually indices do have adequate breadth so that one company does not have inordinate impact on the index performance.
This is why index investing is a good way to minimize nonsystematic risks and enhance portfolio efficiency.
Indices Address Quality Change
With individual assets, you need to carefully monitor their changing risks and return prospects. A true buy and hold may not be wise. You may need to divest assets whose fortunes change and add new assets with better long-term potential.
With index investing, this process is built in to some extent.
Individual index components may change over time. As previously good companies fall, they are deleted from the index. And as new companies rise in value and prestige, they are added to their appropriate indices.
Not an exact science in any sense, as there are many factors that dictate inclusion in a specific index. But over time, there is a tendency for poor quality companies to be phased out and replaced with better potential components.
But even though the index components adjust over time, you only own the single index fund itself. This allows you to follow a buy and hold strategy with the fund.
Weak companies will leave the fund’s portfolio and other companies on the upswing will enter. In the extreme, over a long period the entire index could change. Not likely, but possible.
Yet you can continue to hold the same index fund throughout your entire holding period.
Additionally, there is less work for you to monitor the portfolio holdings. You only need to track the fund results itself.
While I tend to advocate a buy and hold investment strategy, I do so in the context of my overall investment program. That is, investing primarily in low-cost index funds.
I am much less keen on buy and hold for non-diversified assets.
If you intend to invest in individual companies, ensure that you monitor their performance and expected future results. As times change, companies that appeared solid may downgrade in relative value. Be ready for quality degradation and, if you think it is permanent, do not hesitate to divest.
But for well-diversified investments, a buy and hold strategy should be effective. Especially if you incorporate a couple of tweaks to the standard methodology.
We will look at those tweaks shortly.