Buy and hold strategy - What are the advantages and drawbacks?
"Buy and hold" is a popular stance amongst many investors who prefer to hold their investments for the long term and not give in to the short term fluctuations in the market. The strategy certainly works as it prioritises long term stability over short term profit. Many well-known investors have proven the strategy's ability to yield consistent returns.
In this article, we look at the "buy and hold" investment strategy and answer the following questions:
Buy and hold is a well-known investment strategy where the investor selects his financial assets (whether stocks, bonds or real estate) and retains them for the long term without reacting to market fluctuations. It is a passive investment strategy where the investor forgoes short term volatility and gains to keep a stable portfolio. This strategy is well-received because it works and has shown to outperform other investment methods on average. Many well-known investors have tried and succeeded through buying and holding.
The logic behind this strategy stems from the fact that investments, no longer how risky it is, is more likely to generate consistently higher returns because of compounding. And markets are known to go up rather than down. Of course, investors must adhere to the buy and hold strategy with a certain kind of mindset. Investors must buy those expected to exceed in value in the long term and not sell when the prices fall. Investors must refrain from market timing because that is not their investment goal.
Buy and hold has a considerable amount of benefits for the investor. Hence, many investors put their faith in it despite recognising that the growth will be slower. Equity holders, mostly, value their investments because they have ownership of the asset of the equity, and ownership is not to be treated as a short term tool. The following are the most common benefits investors get to enjoy through buy and hold:
- Higher returns: Buying and holding have generated 9.9% for large caps and 12.1% for small caps on average despite decades of financial turmoil. This is simply due to compounding, where over the long period, investments, especially equities, generate high ROI
- Taxes: Buying and holding enable investors to get a favourable rate on capital gains taxes. Since capital gains are only taxed after the investment is sold, long term investments will allow investors to delay it until when it is sold. This is not possible for short term investments because investors will sell their holdings multiple times, and therefore, investors will pay more in taxes
- Reduced costs: Much like the taxes, selling and buying constantly incurs transaction costs, and the more you trade, the more you spend on the fees. Buy and hold favours investors in terms of lowering those costs as there will be fewer trading
Despite generating good results on average, buy and hold should not be treated as a superior method to others. Granted, studies have shown consistent, stable returns, but it only supports investors whose goals aligned with the strategy. As such, there are few drawbacks of buy and hold that investors should consider, in the following:
- It is time consuming: It takes a lot of time to reap the benefits of buy and hold. Even after a decade, you may not be able to receive the reward that you expected. A good example is that of utility stocks which have since been stagnant in growth. While not risky, there are opportunities that the investor is missing, which he can simply mitigate by diversifying between short term and long term instruments or trading index funds
- Not immune to losses: Just because an investor expects the investment to go up in value does not mean it will. Investors can pick investments that will lose significantly over time. This is perhaps the largest risk attached to the buy and hold strategy
- Not immune to fluctuations: Long term investment does not ensure that your assets will not face fluctuations. Although the fluctuations will remain for a short period, the overall value may increase significantly or decrease even if you do not incur major losses
- Restricted liquidity: By choosing to buy and hold, you are giving up your access to cash. Since the money is in it for the long haul, you will be unable to withdraw whenever necessary. Therefore, investors need to set aside liquid funds before making investments to ensure that they have access to funds during emergencies
- Discipline: To buy and hold means you are in it for the long term, and that means you cannot seek other opportunities around it. Even when you see short term profits, you have to force yourself to adhere to the strategy simply because your goal is long-term. In practice, this is difficult, especially when you see no growth or, worse, losses
- Missed opportunity: Since investors' goals are to hold their investment for the long term, they are forgoing profits from short-term trading. While it works, investors often miss optimal times when they could have sold to reap the benefits simply because they feel that the value will increase more in the future. Again, while the belief is valid, it is still propagated by emotions, bias and general aversion to risk. There are plenty of investors who profit regularly from short term trading. Successful investment does not mean holding on to your investment long time. It also means yielding results
Like any investor or trader, buying and holding require a sound risk management strategy to be implemented. The investor must be willing to put a stop to the investment before the losses compound. Buy and hold remains the preferred strategy and proven in the market since it costs low, it is passive, and it does not require timing the market. However, investors are still missing out on opportunity costs and potentially be inviting losses by betting on their growth expectations.