What are the potential advantages in using a Buy and Hold investing strategy? For investors: ease of use; consistency with investment theory; promotes good investing habits. Buy and Hold also works well when combined with Dollar Cost Averaging (DCA) and a passive investment management approach. Strategies that I also recommend.
“Why is Buy and Hold an ‘easy’ investment strategy?”
Buy and Hold is very easy. For investors to understand. To implement. And to maintain.
You identify an investment. Buy it. Then hold until you reach your financial objective’s time horizon.
Sometimes, Buy and Hold may be too easy. As we will discuss in future episodes.
“How is Buy and Hold consistent with investment theory?”
In prior episodes, we have seen that assets appreciate over time. If you buy and hold an investment, over the long term it will grow in value. The greater the investment risk of the asset, the greater the growth.
“How will Buy and Hold improve my investing habits?”
Much like we saw with DCA, Buy and Hold will improve investing consistency and discipline.
Without worrying about when to buy and sell an asset, Buy and Hold takes emotions out of the equation. Making the investment process more consistent and disciplined.
“Why does Buy and Hold work well with passive investing?”
Buy an asset. Then hold it through the time horizon. With no trading, costs remain low.
Perfect for passive investors. Perhaps, too perfect (this is what is known as foreshadowing!).
“And DCA?”
Again, identify the “best in class” asset. Then, slowly add to that position over time using DCA. When you reach the financial objective’s time horizon, divest.
A Buy and Hold strategy will have lower transaction costs than a more active approach.
It may also trigger fewer taxable events. If you hold your investments in a taxable investment account, every time you sell, you may incur (hopefully) a capital gains tax. The sooner you have to pay tax, the less cash you have available to reinvest and grow.
Under Buy and Hold, you will have fewer dispositions. Resulting in fewer taxable events. The longer you can let your wealth compound in your own accounts, and not the tax-man’s, the better.
As well, there is likely an opportunity cost that comes from actively trading. In “Episode 38: Investor Behaviour”, we saw the portfolio growth impact from minimal misses in timing the markets.
Between January 1, 1980 and December 31, 2018, had you missed out on just the 5 best market days of the S&P 500, your portfolio would have a 35% decrease versus being fully in the market the entire time. Missing the best 30 days out of 13,870? Your portfolio would be worth 81% less.
A Buy and Hold strategy might have been better than jumping in and out of the S&P 500.
Another investing debate involves ongoing portfolio maintenance. Should you buy an asset and then hold it “forever”? Or is it wiser to more actively trade investment holdings? At the extreme, high frequency (a.k.a. day) trading. Or somewhere in between day trading and never selling. An introduction to the “Buy and Hold versus Active Trading” debate.
As the name suggests, you identify an investment. You purchase it. Then hold it throughout the entire time horizon. That may be 3 year time horizon in amassing a down payment on a new home. It may be 40 years for your retirement.
“Is Active Management the same as Active Trading?”
Yes and no.
Active management is the investment strategy. Where asset managers decide they will identify good (and bad) investments and market timing opportunities. Then trade accordingly. Many professional money managers take a longer term approach to their holdings. Although, in this context, longer term may be 2-3 years. Not 40. Identify strong assets, buy, then hold until the target price is reached or circumstances change.
Active trading is more the investment tactic to achieve one’s strategy. Though, not always. Depends on the nature of the investor and strategy.
Strategy is the overall, long-term, planned approach. Tactics are the short term processes used to implement the strategy.
For me, active management typically means I identify an investment strategy. Perhaps outperforming the US large cap equity market. I comb through the S&P 500 index and identify the best stocks. Invest in them and ignore the rest. I also over or underweight sectors or stocks based on overall market conditions. The timing aspect. Through these I should beat my benchmark index.
Active trading is the implementation of the strategy. Maybe I determine only 50 stocks are worth owning. I buy them and trade as they reach the target price, a better holding is determined, or a market shift is anticipated. The frequency of the trading is a reflection of meeting my strategic objectives. Not just trading for the sake of trading.
Yes, the same thing. But usually a different meaning when discussed.
And yes, some investors do trade for the sake of trading.
“What is High Frequency trading?”
Also known as day trading, these investors can be very active. Possibly buying and selling the same holding multiple times in a single trading day.
Day traders normally use quantified technical analysis to identify price inefficiencies in assets. Or pricing trends. They may buy and sell in rapid fashion to take advantage of these small variances.
In this case, the high frequency trading is its own investment strategy.
“Which approach do most investors utilize?”
Most investors are not day traders. That area is more of a niche that requires special skills, experience, and time commitment. As well, these investors often require significant capital to invest.
That said, most investors are not hold forever, either.
Most investors buy when they believe the markets are down or a specific investment is trading at a discount to fair value. These same investors may divest when they believe the market or asset is over-valued. Perhaps they sell and move on to other investments. Or they wait for a downswing and then repurchase the same holding.
Market timing, type of asset, and emotional considerations all play a role in trading frequency. My general belief is that the average investor trades too frequently and that hurts performance and portfolio growth.
“What part of the spectrum do you think is the sweet spot?”
How active one should be as an investor tends to be more a function of the asset itself.
If you are invested in a well-diversified, low-cost, index fund, that is an investment that can be held forever without issue.
If you are invested in non-diversified or highly volatile assets, you may need to monitor more closely. And fine tune periodically.
I tend to prefer well-diversified index funds for investors. So, I am more on the hold forever side. However, “buy and hold” does not mean “buy and forget”. There must be mechanisms in place to ensure the quality assets you own remain quality assets in the future.
A quick introduction to Buy & Hold. We will get into more nuance over the next few episodes on the relative advantages and disadvantages of this approach.
I generally like the buy and hold investment strategy.
Assuming, that is, you passively invest in a well-diversified, low-cost portfolio.
But I think that a buy and hold strategy needs a little tweaking for best results.
One such tweak involves the need for periodic portfolio reviews.
There is no hard and fast rule as to the frequency of portfolio evaluations. The number of reviews should reflect a few factors. As these differ between investors and their portfolios, so too will the periodicity of portfolio assessments.
Portfolio Risk Level
The timing of evaluations should be connected primarily to the risk of the portfolio.
With a relatively low risk, well-diversified portfolio of mutual and exchange traded funds, annual reviews may be adequate.
As portfolio volatility (i.e., standard deviation) rises, you may want to increase the frequency of evaluations. Maybe semi-annual reviews for portfolios with moderate risk levels. Perhaps quarterly reviews for portfolios with high standard deviations.
For portfolios that are not well-diversified, quarterly to semi-annual assessments are prudent. This holds true even for lower risk portfolios. And the less diversification, the greater the need for more frequent reviews (the exception being for single investments in extremely low risk assets such as Treasury bills, term deposits, etc.).
The logic of increased frequency for high risk or weakly diversified portfolios is that external factors can have significant and rapid impact on highly volatile and/or non-diversified investments.
For example, perhaps you have a large concentration of investments in the Middle East. Given all the political turmoil there, you would want to monitor your assets very closely. If you wait a year to do an evaluation, you may find that the situation when you last reviewed has radically changed concerning your holdings.
General Market Volatility
Over time, certain events can cause excessive volatility in the markets. Most of these are systematic risk factors. In our Middle East example above, socio and geopolitical variables can impact individual investments.
On the down side, events may include inflation, high unemployment, political turmoil, stock market crashes, wars, natural disasters, and so on. On the positive side, there may be long bull markets due to the opposite events, such as low unemployment, low inflation, peace, etc.
The greater the general market volatility, the greater the focus should be on your portfolio.
And, in part, because a well-diversified portfolio of passive index funds should reflect the market itself. As general market volatility increases, so too does your portfolio. Therefore, you should increase your amount of reviews accordingly.
Investor Personality
Periodicity of portfolio reviews will also reflect your personality and investor risk tolerance.
Not that it should, but an individual’s personality plays a role in how they manage their assets.
If you are a detail oriented person, you will likely be more comfortable reviewing your assets monthly, or even weekly. No doubt using spreadsheets or investment software to drill down into the numbers. If you are quite relaxed about life, then even an annual check-up scribbled on the back of a napkin may feel onerous.
The same applies to one’s investor risk profile. Low risk investors will normally want to monitor their portfolios more closely than a high risk investor. The opposite of what should be done, but it ties into their personality in many cases.
Given the importance in generating adequate wealth for a comfortable retirement, I suggest you set aside any personality traits that lead you to defer reviews. Put in a little time now on performing proper evaluations and you will reap the benefits down the road.
Material Change
A material change is anything that alters your investment perspective.
That could be a systematic variable that impacts your portfolio. War, hyper-inflation, depression, etc. Factors that affect economies and have wide ranging impact on investments.
Or nonsystematic – company specific – variables. The Department of Justice in the U.S. going after Facebook or Google. An oil company you own shares in, undergoing a takeover.
Material changes also reflect your own life. Young, single, you may design a higher risk portfolio. Get married and have a child, perhaps your risk profile lessens. Life insurance becomes an interesting topic.
A material event may be far reaching in impact. Or it may relate to a specific investment. Or the world may remain the same, but features of your life change.
A material event needs to be addressed in real time, not as part of an annual review. If your mining company is being investigated for environmental destruction in January, you likely do not want to wait until December to consider the impact on your investment.
That said, there is lots of media “noise” out there, over-emphasizing variables both too good and too bad. Things that cause assets and markets to swing wildly, only to reverse back to normal in the near future. It takes a bit of experience and knowledge to sort through the wheat from the chaff.
What Next?
Okay, so you should review your investment portfolio periodically.
But how should you efficiently do a review?
And what should you do after a review?
Good questions.
We will look at portfolio benchmarking and review procedures over the next few weeks. Then we will cover what to do if your portfolio gets out of alignment with your investment plan.
A long-term buy and hold strategy can work with individual, non-diversified assets. For example, shares of Amazon or Swiss Re. Or General Electric Capital bonds. Or the Japanese Yen.
Yes, but …. I would not likely recommend buy and hold forever with individual, non-diversified assets.
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.
In a previous post, we looked at how Eastman Kodak was once an elite company. A Dow Jones 30 component for 74 years. In 1976, 85% of all cameras and 90% of all film sold was Kodak. Yet in 2004, Kodak’s flagging results led to its removal from the Dow Jones 30. In 2012, Kodak filed for bankruptcy.
Conversely, we also saw how Apple was down and out in the mid-1980s. Yet in the span of a few short years, Apple’s fortunes completely reversed. Today one might argue that Apple is the (less dominant) Kodak of the 1970s. Does that mean Apple may be bankrupt inside 40 years? Laughable, yes. But probably the idea of Kodak moving from a 90% market share to nothing was also laughable. Technology changes. Market demand changes. No company is ever safe.
25 years ago, there was no Google, Amazon, Facebook, Netflix, etc. Or consider the size and history of young public companies like Biogen, Nike, Starbucks, Celgene, etc. Given their track records, would they be obvious long term investments? And for every Amazon, you also had a bunch of Webvan, Pet.com, eToys, etc., that were launched in the dot com craze of the 1990s. Companies that took off, then crashed, and were never heard of again.
Hindsight is usually 20-20. If you look at newly listed companies in the last 5 years, are you confident which will be dominant in 25 years? Versus those that will be poor investments?
If you invest in individual companies, I suggest you spend more energy monitoring their performance and prospects. A good rule of thumb is that the greater the risk of the asset (i.e., 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.
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 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. And those criteria differ between indices. But over time, there is a tendency for poor quality companies to be phased out and replaced with better potential components.
We saw this with our Eastman Kodak example above. An emerging giant entered the Dow 30 in 1930. Grew until by 1976 it controlled 85-90% of its market. However, as fortunes ebbed, by 2004 Kodak was no longer in the Dow 30. Perhaps foreshadowing its continued fall towards bankruptcy in 2012.
As Kodak grew in size and importance to the economy, it joined the index. As it fell, it was replaced by the next Kodak. In 2004, the Dow 30 deleted Kodak, AT&T Corp, and International Paper. They were replaced by AIG, Verizon, and Pfizer. in 2008, AIG was replaced by Kraft Foods and the cycle of change continued.
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.
Conclusion
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.
A legitimate concern with a buy and hold investing strategy is that it may underperform active management during fluctuating and bear markets.
True. But as we have seen in prior posts, the ability of active managers to correctly time market movements is questionable. So, yes, in a perfect world, active would be preferable. But in the real world, the added costs of active management and the inability to time market shifts does not tend to create alpha (i.e., outperformance by managers).
Today we will review how to protect your wealth during periods of market volatility when using buy and hold.
Long Time Horizon
One’s overall investment horizon should be relatively long-term. Of course, within that longer time horizon for retirement, there will be a few short and medium term financial objectives. But the bulk of your focus will be long term.
As stated above, in a perfect world active management may perform better than passive in volatile markets. I say “may” because who knows. Would you have bought and sold at the right times? Or would you have compounded your losses through even worse timed trading?
As we saw last week, the “experts” overwhelmingly got the Trump election economic impact wrong. In the last 5 years, you can also look at the general consensus that inflation and interest rates would increase significantly. Nope. Had you shortened fixed income duration based on this consensus, you would be worse off.
The BREXIT on June 23, 2016 was another tale of doom and gloom. The pound fell to 1.29 USD and “some commentators have warned sterling could yet slump to parity with the dollar.” Instead, the pound currently trades at 1.25 USD. Or post-BREXIT vote, the pound traded at 1.17 Euro. Today the pound trades at 1.11 Euro. And yes, in the pre-vote optimism to remain, the pound rose to 1.45 Euro. A big crash. But if you ignore the run-up to the vote in mid-2016, you will see the historic trading range for the 5 years before the vote was pretty much in a 1.15 to 1.25 trading band. Further, consider the FTSE 100 stock market index. It traded at 6338 on June 23, 2016. Currently, it trades at 7537. Not as impressive a growth rate as the U.S. stock markets, but a decent gain of 18.9% over the period (not factoring in any dividend distributions to investors). So while not wonderful, not the apocalyptic aftermath predicted by many “experts” (as they tried to scare voters into staying).
In these two examples, the “experts” got it very wrong. Had you traded based on their advice, you would be much worse off than simply staying the course. Will they get it right next time? Perhaps. Perhaps not.
Now some of you reading this are thinking, “Hey, I don’t have 20 or 30 years to invest. What can I do?”
If you recall our discussions on investor profiles and investment policy statements, you realize that your asset allocation is geared, in part, to the phase in your life cycle.
Over the course of your life cycle and ever evolving investor profile, the amounts that you allocate to cash, fixed income, and common shares will change. As you near retirement, you will be shifting more of your wealth into lower risk (i.e., less volatile) assets. For example, we saw how one’s allocation to equities changes based on the life cycle phase.
This will also address problems with general market volatility.
When young, with a long time horizon, you can handle more volatile assets in your portfolio. As your risk tolerance (and ability to withstand volatility) decreases through your life cycle, you shift into a higher percentage of lower risk asset classes. As your financial time horizon nears, portfolio risk (and impact of market volatility) lessens.
A diversified portfolio prevents you from having all your eggs in one basket. Whether that be a specific asset within a market or an individual market within the whole spectrum of investment options.
If you have 50% of your wealth in shares of Credit Suisse, your portfolio returns will reflect the results from Credit Suisse to a significant degree. Or if you have invested 80% of your assets in the U.S. equity markets, your portfolio will mirror the ups and downs of the U.S. equity markets.
Either of these may generate positive returns during bull markets, but they will create problems during down periods.
However, by diversifying throughout various asset classes, you can spread the risk of any one market throughout multiple asset classes.
Not Just Diversified, But Well-Diversified
A diversified portfolio is a collection of different assets.
A well-diversified portfolio reflects a proper mix of assets, such that you minimize asset correlations.
If you recall our discussions on asset correlations, holding assets with low or negative correlations will provide some built in protection against market volatility. As the value of one asset rises, the value of a negatively correlated asset should decline.
While you may give up some potential return by never being fully invested in rising markets, you will also never be fully exposed to falling markets.
This offers a defence against market downturns.
Dollar Cost Averaging
Another strategy I have espoused is dollar cost averaging (DCA).
If you believe over the long run that appreciating assets do, in fact, appreciate, then down markets provide buying opportunities.
We have covered the above points previously in significant detail. I reiterate them to show how we have already take steps to protect our portfolios from legitimate potential problems with employing a buy and hold strategy.
Nest time, we will look at tactics we have not previously discussed.