The pros and cons of the passive buy and hold strategy

There are basically two ways to make money in the stock market: fast and risky or safe and stable.

Although traders adhere to the former paradigm, most investors fall into the latter category. With the slogan “Buy Low, Sell High”, these investors look for undervalued stocks and buy them, with the goal of holding these positions for months or even years. For them, a company’s strong fundamental characteristics and sound management have replaced all the chaos and volatility inherent in the market, and over time, stocks will bring them a generous return on capital.

After all, who doesn’t want to own Apple Inc. (APPL) at $6 per share or Netflix, Inc. (NFLX) at $17 per share? If you are a potential buy and hold investor, please read on to understand the advantages and disadvantages of this popular and efficient strategy.

Key points

  • The buy-and-hold strategy is a long-term, passive strategy in which investors will maintain a relatively stable investment portfolio over time regardless of short-term fluctuations.
  • The success of buy and hold has been proven by historical data and is the preferred investment strategy of industry giants such as Warren Buffett.
  • Buying and holding is also beneficial to investors who do not have a lot of time to spend on researching the market.
  • The biggest disadvantage of the buy-and-hold strategy is that it takes up a lot of money.
  • Like all investors, buyers and holders should use diversification to fully protect themselves from risks.

advantage

Let’s take a look at the many advantages of using a buy and hold strategy.

it works

Quite simply, the buy and hold strategy has been proven time and time again to make investment capital gain exponential returns.

The list of top buy-and-hold practitioners is a veritable Who’s Who of the greatest investors of all time. Maybe some of these names might sound the alarm? Warren Buffett, Jack Bogle, John Templeton, Peter Lynch, and of course Buffett’s mentor and father of value investing: Benjamin Graham.

Okay, so maybe your stock selection skills are not as sophisticated as these industry giants. It’s ok. Just put your money in an index tracking fund, such as SPDR S&P 500 (SPY) Exchange Traded Fund (ETF), and forget it in two to three years. Statistics are all by your side. From 2010 to 2020, only 24% of actively managed funds performed better than passive funds, and you don’t have to spend your hard-earned money on high management fees​​​

More time-saving

Are stock charts as foreign to you as another language? When you hear the word “head and shoulders”, do you immediately think of shampoo? Can’t tell the difference between a simple moving average and a relative strength index (RSI)?

Your technical analysis may require some work, or you may just be part of a large group of people who do not believe in artistic efficacy. Over the years, academics and successful long-term investors have been knocking on the table, on the grounds that trying to “time” the market is wrong. The statistics will be consistent; research shows that the market is extremely random (and causes anomalies).

As Nobel Prize winner William Sharpe concluded in his landmark 1975 study “The Possible Benefits of Market Timing”, the market timer must be accurate at least 74% of the time to beat the index .

In other words, leave the tickles to the trader. Just like buying a house, buyers and holders look at the overall characteristics of the market, assets and the possibility of future growth, and then let the investment do its own thing without worrying about trying to find the “perfect” entry and exit, or constantly checking price.

Facts proved

Buying and holding and general investment are what is taught in academia and various portfolio management courses, because B&H is almost entirely based on fundamental analysis. Unlike its technical counterparts, fundamental analysis has little room for guesswork.

The balance sheet, income statement, and cash flow statement are all static, and there is no room for subjectivity. Of course, forecasting growth, such as through a discounted cash flow model, is highly subjective. However, comparing and analyzing companies through ubiquitous price-to-earnings ratio (P/E) or EBITDA multiples does not have much room for imagination, and it is an indispensable factor for finding long-term high-value stocks.

Preferential tax treatment

Last but not least, buying and holding is very useful for long-term capital gains. Any investment held and sold for more than a year is eligible to be taxed at a more favorable long-term tax rate instead of a higher short-term tax rate.

shortcoming

Bundled capital

The biggest disadvantage of this strategy is its huge opportunity cost. Buying and holding something means that you are bound by the asset for a long time. Therefore, buyers and holders must have self-discipline and do not chase other investment opportunities during this holding period. This is difficult to put into practice, especially if you have purchased lagging inventory.

It takes time to see growth

To add one last point, buying and holding is also completely time-consuming. Just because you hold the asset for 10 years does not mean that you are entitled to a generous return on the time and capital you invested.

To give an example: look at the difference in returns between sluggish utility stocks and fast-growing biotech companies. However, remember that the opportunity costs associated with poor choices can be mitigated by diversifying or simply buying and holding index funds. However, for the former, the performance of the portfolio based on a small number of high-flyers may be dragged down by the laggards.

In addition, nothing can stop investors from choosing and holding the entire portfolio by mistake. Regarding the latter point, index funds have also been shown to not be immune to certain events, such as crashes.

Market collapse

Finally, just because a stock or index fund has been held for many years does not mean it is invulnerable. Although the end of the world will completely destroy the markets of advanced economies, crashes do happen from time to time.

If there is a pullback, leading to a long-term bear market, the investment portfolio that you buy and hold may lose most if not all of the gains. In this case, investors may become overwhelmingly dependent on their assets and simply average declines in order to get better.

While sound, well-selected stocks can and have rebounded, some stocks will fall in the process and destroy the portfolio.

Take the famous Enron company as an example. Enron was once regarded as the darling of Wall Street, and its stock was valued at around US$90 per share in mid-2001. After discovering his illegal accounting practices, when the company was dissolved, the stock price fell all the way to $0.60 per share.

In addition, if investors have substantial risk exposure not only to a single stock but also to entire industries that have been eliminated due to technological progress or other reasons, their investment portfolios may shrink to zero without proper diversification.

Once again, buyers and holders, like any other investor or trader, must have a prudent risk management strategy or be willing to unplug before losses accumulate. Of course, this is easier said than done.

Bottom line

Buying and holding is still one of the most popular and effective stock market investment methods. Practitioners of this strategy usually do not have to worry about market timing or make decisions based on subjective patterns and analysis. However, buying and holding has a large opportunity cost of time and money. Investors must act cautiously to prevent market crashes and know stop loss/take profit.

.

READ ALSO:   4 key factors for building a profitable investment portfolio
Share your love