Buy and hold explained: is it really the winning strategy?
Buy and hold is a simple investment strategy to implement, but it is not infallible – there is plenty that could go wrong. We examine the pros and cons.
What is a buy and hold strategy?
The theory behind a buy-and-hold strategy is straightforward. Buy an asset and hold it until you need to sell it, during which time you should have benefited from years of capital appreciation and income payments.
While a simple concept, it will not work for everyone. Here we outline some of the pros and cons you will want to consider.
Pros of a buy and hold strategy
1. Buy and hold means fewer fees
It will cut down on transaction costs, which for small portfolios can be very injurious to longer-term wealth creation. For example a £10,000 portfolio which grows at 6% a year net of fees over 20 years would be worth £32,000 versus £38,700 if it grew at 7%.
Whilst it is true that large cap stocks have very tight bid-ask spreads, and dealing commissions are undoubtedly much better value due to online competition, unless UK stamp duty of 0.5% (on purchases) is scrapped there is a clear cost to overtrading.
Read more about how fees and inflation are eroding your savings
2. Tinkering less may mean greater returns
You remove the temptation to tinker through buying high and selling low. Asset management firms delight in providing statistics that show if you’d have missed the ten best trading days over X number of years, your return would have been commensurately lower than that of the index.
The historical returns of markets over time show ‘negative skew’, which is to say that losses happen more suddenly than investment gains. However, the best trading days usually follow the worst down days, which investors may miss if they sell on dips.
3. The evidence supports buy and hold investments
Evidence strongly supports a buy and hold strategy. In aggregate, actively managed funds, when measured against their reference indices over time, have a long track record of underperformance.
Nevertheless, actively managed funds can be the only way to access some asset classes (e.g. small caps or physical property funds). Morningstar’s Active/Passive Barometer report concludes that “investors would greatly improve their odds of success by favouring low-cost funds, which succeeded far more often than high-cost funds over the long term”.
Whilst buy-and-hold can be an effective strategy for institutional investors whose main requirement might be to match an index return over time, it does have short-comings for individuals, where asset allocations should evolve to suit an ever-changing investment horizon.
For example, you would not buy and hold bonds now, if your retirement date is in 40 years, nor would you hold an actively managed fund, or a single company over the same period. Managers retire, funds close and individual companies may be taken over or go insolvent.
Here are some things to be aware of when following this strategy:
Cons of a buy and hold strategy
1. Buy and hold strategies could miss out on trends
Buy and hold assumes that you have foresight to predict which markets are going to make good gains in the future.
Many investors will gravitate towards making larger investments in the index that has made the best gains over recent history. The US has been an exceptional performer over the past decade, just as Emerging Markets had been the star performer over the previous 10-year period.
Today the US has a 62% weight in the MSCI World Index, which could prove to be a sub-optimal starting allocation if it were to underperform over the next decade or more. For reference, Italy’s FTSEMIB Index is still more than 50% below its 2007 high.
Similarly, we may think we have the knowledge to pick long-term winners in consumer businesses that we know well (such as Unilever), and which should profit from future global economic growth, but think what might happen if management leveraged up the company balance sheet and more competition emerged.
2. Buy and hold investments could suffer from hindsight bias
Your decision to follow a buy and hold strategy might suffer from hindsight bias. It may seem obvious now that buying Apple and Amazon were the key to future riches, but it was less so at the time.
In making long-term investments, you must accept that you have little ability to predict how that investment will perform. It’s possible that UK property might be a wonderful 20-year investment, or a terribly disappointing one – supply and demand is just one of many factors which determine the return profile of every investment.
3. Buy and hold ignores asset re-allocation
Your asset allocation needs to adjust over time. In the case of someone retiring in 20 years, they will probably want to take less risk and focus on generating income.
A buy-and-hold strategy does not allow for determining which investments will you hold, and how you adjust that asset mix over time. You sell one asset, to buy and hold what…?
4. Diversification is overlooked in buy and hold
Diversification is crucial. Poorly constructed buy-and-hold portfolios can lose large gains very quickly. Creating balanced portfolios is a skill, it’s not as easy as holding a collection of random investments and hoping for the best.
Psychologically it can be difficult to remain invested if all your eggs are in one basket and the market drops. Holding a considerable chunk of your investable wealth in a diversified buy and hold strategy, while being prepared to capitulate with a smaller portion of investments might be more realistic.
Is buy and hold a good strategy for you?
If the opposite of buy and hold is trading actively to try and beat the markets, there is plenty of middle ground between the two.
Buying-and-holding a proportion of your investments can work well, and better still if you can regularly add to them you greatly reduce the chance of buying at the very peak of a market and then witnessing those investments fall considerably in value. We have outlined before how market crashes and inflation can derail your investments, which suggests that being fully invested in equities can result in adverse outcomes over long periods of time.
There is no magic bullet to investing over a prolonged period, and as ever the following simple investment rules offer the best chance of meeting your investment goals:
1) Start early
2) Keep the costs down
3) Don’t overtrade