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.
We have now compared Lump Sum versus Dollar Cost Averaging (DCA) investing. Lump Sum may outperform in long run returns. DCA may prove better for “smaller” investors and in dealing with shorter term market volatility. DCA may promote investor consistency and discipline. DCA may also help create well-diversified, high-quality investment portfolios.
“Does Lump Sum investing provide superior long-term growth?”
Yes. With a few caveats.
Studies tend to assume that Lump Sum investors have cash readily available to invest on day one. In reality, most investors do not have funds to invest up front. It may take time to accumulate cash to make the lump sum investment. And that needs to be factored into the calculations. Often, it is not.
In the long run, assets appreciate. But in the short to medium terms, you will face significant volatility. When you invest and your holding period can greatly impact portfolio returns.
“How can DCA assist is dealing with short to mid-term volatility?”
If you possess strong market timing skills, then Lump Sum is great to take advantage of price swings.
Unfortunately, even the professional asset managers are not very good at timing market movements.
DCA does help smooth out price volatility in your portfolio. Because you are investing a fixed amount each period.
Investing $1000 every 4 months? On January 1, the investment trades at $10. You are able to purchase 100 shares. On May 1, the asset trades at $20. Your $1000 only buys 50 shares. On September 1, the asset trades at $4 and you buy 250 shares. At December 31, you own 400 at an average cost of $7.50. A lower adjusted cost base than if you had invested the $3000 at $10 per share on January 1 and received 300 shares.
Of course, if there was no volatility, only straight growth from $10 to 15, DCA would underperform.
And yes, there may have been dividends missed that also impact total return. And the additional transaction costs. So there are other factors to consider when comparing.
Most investors do not have cash sitting around, waiting to be invested. Lump Sum investing, while perhaps providing better performance, may not be practical for the average investor.
If it takes 6-12 months to save before making a Lump Sum purchase, that negates some of the outperformance versus DCA.
“How can I improve investing consistency and discipline by using DCA?”
Consistency and discipline go hand in hand.
Consistency is more about the actual process. If you set up a system where you automatically invest $300 per month, that is consistent.
It also has a behavioral finance aspect. Like a phone bill or Netflix account, you adjust to having $300 less disposable income every month. In short order, you “forget” about your investing funding. Compare with having to find $3600 on January 1 for a lump sum investment. A bit different on the mindset.
Discipline, to me, is more the emotional side of consistency. Markets are up. Will they fall? Should I buy into a bull market? Especially if “television talking heads” are warning of a correction. Markets are down. Should I buy when everyone else seems to be selling? Maybe I should wait until the bottom is reached and things are picking up again.
As opposed to just investing that $300 per month and not worrying about the short term ups and downs. A smarter way to build a portfolio. And definitely helps with emotional discipline when your stomach (and the “talking heads”) are creating uncertainty in your actions.
You can effectively diversify a portfolio under Lump Sum.
But it is something that works very well with DCA. Especially for smaller investors.
Mutual funds are usually set up for small investors, making periodic investments of relatively low amounts. You also can receive partial units in a fund, allowing you to invest all your capital immediately.
While not the same process with Exchange Traded Funds (ETFs), often pricing of ETFs is such that buying shares is not an issue. You tend not to see ETFs priced like Google (USD 2526 at June 28, 2021) or Amazon (USD 3430). Instead for diversified ETFs, prices are more reasonable. If we look at iShares, we see the Dow 30 (IYY at USD 108), S&P 500 (IVV at USD 428), rest of developed world in EAFE (EFA at USD 80), or Emerging Markets (EEM at USD 55).
We also see that ETFS and mutual funds offer almost every possible investable market. Small cap or mega? Value or growth? Specific sectors? Individual countries? And so on. Usually at reasonable share prices for all investor levels.
“Finally, how can DCA help improve my portfolio quality?”
Investing in “quality” assets is actually more difficult than it seems.
If professional money managers could consistently pick the winners, they would easily outperform their benchmark indices. Which hold both the good and bad assets. And, as we have discussed, there are reasons why outperforming is hard.
A DCA strategy works best in a passive approach. Investing in index funds. For most indices, there are minimum requirements to be included.
For example, the S&P 500 is essentially the largest 500 companies traded on the NYSE or NASDAQ. Essentially, as there are some other criteria, including positive earnings over time. As once-dominant companies weaken, they are replaced on the index with up and comers.
In 1999, long-term dominant companies Goodyear Tire, Sears & Roebuck, and Chevron all left the Dow 30. Replaced by Microsoft, Intel, and Home Depot. In 2015, AT&T, a Dow component since 1916 departed. In its place, Apple. And so on.
Also, indices like the Morningstar Dividend Yield Focus Index rely on screening criteria for index inclusion. In this case, Morningstar takes its US Market Index components (97% of US equity market stocks) and screens them for the top 75 dividend producers. Criteria reflect financial health and dividend related areas. As it is only 75 holdings, it is easy for the bottom tier to vanish and new stocks to enter over time.
While you may only hold the single index, there will be turnover of the underlying assets.
How can Dollar Cost Averaging (DCA) improve investment quality versus Lump Sum investing? While investors can still find quality assets under a Lump Sum strategy, DCA is very useful in building quality portfolios. Especially for smaller investors.
“Why do you believe that investment ‘quality’ is an elusive concept?”
We have seen this in previous episodes and posts.
If identifying quality investments was simple, then professional asset managers should easily outperform their passive index benchmarks. If I can readily pick the best companies on the S&P 500, I should be able to surpass the performance of all 500 holdings. Even in a capital weighted index (as most are).
“How can I improve my odds of investing in quality assets?”
If you cannot beat the market on a consistent basis, then match the market.
In general, the index itself will tend to have higher quality holdings. Usually, there are criteria for inclusion on an index. And sheer size of a holding also impacts its relative weight in an index, assuming a capitalization-weighted index (as many are). So the holdings themselves, may have some quality.
But quality comes in creating a well-diversified investment portfolio. One that meets your Target Asset Allocation, that is derived directly from your Investor Profile.
A portfolio with minimum tracking error, so that it closely matches the index return. And with low-cost investments, so that your funds grow on your behalf. Not in your bank or fund company accounts.
“You said that ‘quality’ is ever changing. Any examples?”
We look at two companies. One, joined the Dow Jones Industrial Average (Dow 30) in 1930. A dominant company over the decades. In the 1970s, held market share of 85-90% in its key market sectors. Yet, in 2012 it went bankrupt.
The other, a penny stock in the 1980s. Fired its Chief Executive Officer (CEO). Other key employees left. Not perceived as a great investment. In 1997, the original CEO is rehired. In 2015, the company joins the Dow 30. An index commonly viewed as the most prestigious companies in the United States.
Quality can change over time. And often quite quickly, once the shift commences.
“If I buy a plain-vanilla index fund, am I not stuck with the same holdings forever?”
Not at all.
As I mentioned above, most indices have certain criteria for inclusion. As a company’s fortunes rise, it will begin to be included on different indices. As a company slips, it will be removed from an index. And replaced with the stronger company.
In the YouTube episode, we see how much change can take place on the Dow 30 over the last 20 years. Only 30 holdings, but substantial churning within the index.
In buying the index, you own one investment. But the actual investments held within that index may alter over time as asset fortune’s rise and fall.
Also, with market capitalization-weighted indices, relative holdings will shift over time and differ.
When I wrote “A Real Fund Diversification Problem” in June 2020 (one year ago), the top 12 companies of the 500 on the S&P 500 accounted for 29.1% of the total holdings. The bottom 400 companies accounted for 29.6%.
Those ratios are consistent today. In June 2021, the top 12 holdings make up 28.9% of the S&P 500.
As an aside, if you think you are getting exposure to 500 companies (or whatever an index has for holdings), there is a good chance you are not. Currently, 12 stocks have the same impact on the S&P 500 index as do 400.
For more information on this index compositions, I suggest reading “Diversification and Index Weighting”. Very useful to understand the level of actual diversification in a fund.
“So I do not need to review my portfolio?”
While your holdings may shift, you do still need to review the overall portfolio.
Perhaps your personal circumstances have changed, necessitating an adjustment in your Target Asset Allocation. That may require asset class allocation shifts.
Over time, one asset class will outperform another. Maybe your target weight for US equities is 30%. Now you are at 45%. You will need to adjust your positions.
Maybe a new index fund has been created since your last review. Less cost, better tracking. What may have been “best in class” when you initially invested, may change in quality over the years. Had you invested in a fund in 2000, you will find the product landscape – offerings and costs – much different today.
An advantage of Dollar Cost Averaging (DCA) versus Lump Sum investing is that it may help investors better diversify investment portfolios. A look at why DCA may benefit diversification efforts.
I will say, up front, that you can properly diversify an investment portfolio using a Lump Sum approach. But for smaller investors, the typical investor like you and I, DCA can make it easier to diversify.
“What is proportionate ownership?”
Proportionate ownership means owning pieces of an asset. If you want to invest in shares of Google or Amazon, you need USD 2421 and USD 3233 to buy one share each as at June 1, 2021. If you only have USD 500, you cannot purchase 25% of a Google share.
In today’s equity markets, you need a fair amount of capital to buy shares in a variety of companies, industries, and markets to diversify. Which is the big argument for mutual and exchange traded funds. Built in diversification at reasonable prices.
Plus, with mutual funds, you can buy partial shares or units. And very quickly, your fund statements will be filled with owning 128.9245 and 244.1877 units of a fund.
As well, with funds and even stocks, if you sign up for dividend reinvestment plans (DRIPs), any dividends issued will be automatically reinvested in additional units or shares.
“If I can diversify under Lump Sum, where is the advantage in using DCA?”
Yes, you can diversify using Lump Sum. But diversified investment products tend to be geared for DCA investors.
You can easily purchase partial shares or units in mutual funds.
Fund companies typically offer very low purchases once you are in a fund. For example, a mutual fund may require a minimum initial purchase of $1000 (or $2000, $5000). But subsequent purchases are often as low as $50 (or $100, etc.). You cannot do this with Google, Amazon, or even publicly traded ETFs.
And, as you should be investing in no-load funds, there will be no sales commission or transaction fees when you make those low dollar value subsequent investments. Keeping your costs down.
Add in convenience options, such as automated direct debits, DRIPs, tax and performance statements, etc., makes it very easy to create a portfolio that is easy to manage and monitor.
“What are asset-weighted indices and equal-weighted indices?”
Asset-weighted indices, also known as market-capitalization or market-cap, reflect an index that is weighted based on the capitalization of each holding in the index.
An equal-weighted index does not reflect the relative market size of a specific holding.
Consider the S&P 500 index. 500 companies. Under an equal-weighted index, each holding would have a 0.2% investment.
But the S&P 500 is an asset-weighted index. If we look at the relative investments, the top 10 holdings make up 27% of fund capital. That is roughly the same amount of fund capital invested in the 400 smallest companies on the index.
There are pros and cons to each approach. Should Apple, Microsoft, Amazon, and Facebook be treated the same as The Gap, Ralph Lauren, Cabot Oil, or Alaska Air? Probably not.
However, investors who think they get incredible diversification in owning 500 different companies are mistaken. Still a lot of diversification. But more like 40 to 50 stocks, not 500. And probably 20 really can drive the index.
“What about if I want to invest by specific styles?”
Yes, DCA can still diversify outside plain-vanilla generic index funds.
There are many indices that are broken out by investment style. Or, an index is divided by style.
For example, iShares USA. A large ETF provider, with many funds. IVV is iShares plain-vanilla S&P 500 index fund.
If you are interested in value or growth stocks, then iShares offers two funds that split out the S&P 500 growth (IVW) and value (IVE) stocks. If you are not interested in the larger capitalization of the S&P 500, iShares offers small and mid-cap index funds. Or funds that focus on dividend producers.
“Or in alternative assets and hot trends?”
Firstly, investors often get exposure to alternative asset classes within plain-vanilla index funds. If we look at the Toronto Stock Exchange and its TSX Composite. Canada is a country heavily into natural resources. The index alone has 13% in Materials, 13% in Energy, 3% in Real Estate.
Brookfield Asset Management is the 7th largest holding on the TSX. Considered a “Financial” company, it is much more than that. A global company. Its key business lines are real estate, infrastructure, renewable power, and private equity. Brookfield, alone, provides investors with exposure to niche markets and hot sectors. All wrapped up in a plain-vanilla index fund.
That is a big reason why investors typically do not need to add specific alternative or exotic investments to their base portfolios. Create a well-diversified portfolio foundation. The niches will be built in.
But if you are set on investing in niche or hot sectors, there are a ton of index funds.
Again, using iShares as an example. Environmental, Social, and Governance (ESG) index funds. ESG is a very hot investment trend. Low-Carbon and Self-Driving Electric Vehicle index funds. Various commodity funds. And so on. There tends to be passive index funds available in any flavor an investor wishes.