Top 5 Reasons the Buy and Hold Strategy Still Pays Off
The buy and hold strategy has a long history of producing wealth.
Is it still relevant today as in the past? Let’s discuss.
The buy and hold strategy of investing claims that most investors are better off buying an established stock, or preferably a diversified basket of stocks, then holding that stock for the long term. Instead of speculating on particular stocks or trying to time the market, buy and hold investors seek steady returns over a long period of time. This strategy has many advantages over alternative approaches to investing. It produces better results in the long term and is also less demanding on traders. For the following reasons, it is the recommended approach for most investors:
Lower Transaction Costs
Buy and hold advocates note that trading in and out of stocks is wasteful because of the transaction cost involved in making trades. The average trade does not improve an investor’s long-term earnings, but it does incur an immediate brokerage fee. If you buy and then sell a stock, you will incur two brokerage fees in the process.
I first tried investing in the stock market in college, during the stock market boom of the late 1990’s. Like many rookie investors, I was an active trader, making several trades a day. I soon learned, though, that a trade has to be profitable enough to cover the brokerage fees, just to break even. All else being equal, making fewer trades keeps more money in a trader’s pocket.
No Emotional Mistakes
Investors who do trade in and out of the market frequently often make mistakes by following their gut instincts. Human psychology leads many people to buy when the market is up and sell when the market is down; these two trading errors lead to sub-optimal results. Buy and hold investors maintain their positions through the market’s fluctuations, knowing that the market has delivered steady returns over the long-term in the past, and believing that it will do so in the future.
The choice of which stocks to buy and hold forever is up to each individual investor. Generally, advocates of the buy and hold strategy recommend large-cap stocks or diversified baskets of stocks. Speculative, small-cap stocks are typically not recommended.
Dollar Cost Averaging
Another principle that goes hand-in-hand with the buy and hold strategy is dollar cost averaging. It is impossible to know where the stock market will go next, but if you steadily buy small amounts of stock in regular intervals, you will end up buying at the high points and the low points and every point in between. Over the long term, this means that you will buy, on average, at an average buying price. Because the stock market has historically risen at a healthy rate over time, buying at an average price will lead to attractive results.
Rational Perspective on the Market
For most people, buy and hold is the optimal strategy because of the impossibility of beating the market. Amateur investors often believe that they can beat the stock market if they have the right hot tip from the right source. This, however, rarely works out in the investors’ favor.
The stock market has two primary types of investors: individual investors and institutional investors. Individual investors are ordinary people using their salary or other income to create some level of additional wealth or security for retirement. Institutional investors are companies, including hedge funds, banks, and all the rest, that invest in the stock market for strategic reasons. As you would assume, institutional investors have expensive high-tech tools helping them achieve their goals. They employ experts whose sole job is to trade for them. What are the odds that one of the consumer investors will consistently make trades that are more profitable than the trades made by all other investors, including the institutional investors? It is not rational for an individual investor to believe he or she can beat the market.
The idea of beating the market with hot tips is also seriously flawed. Financial scholars cite the “efficient-market hypothesis,” which holds that the current price of a security has already factored in all available information about the security. So, for example, if a news article is released with news items that could lead to profitable trades, one has to assume that out of the millions of people who see the news article, some will instantly make the logical trade suggested by the information contained in the article; as a result, the stock price reference in the article will almost instantly be corrected to reflect the information contained in the article. Anytime you receive a tip, it has to be true that other people know the same information that you receive in the tip. The efficient market hypothesis would suggest that those other people, or at least some of them, have traded on the information, and the price of the stock is now priced accordingly. Not everyone agrees with the hypothesis, but there is much evidence to suggest that it is correct.
Instead of deciding which are the best stocks to buy for short-term gains, a trader should find some good stocks to buy and hold.
Apart from any debate over the profitability of the buy and hold strategy, one great feature of the approach is that it requires far less time than other investing strategies. Most consumer investors do not want to spend hours every day deciding how to manage their relatively small investment fund. With the buy and hold strategy, no such daily maintenance is necessary. The investor simply establishes a regular investment habit, and stops monitoring the daily returns.
For the average investor, the buy and hold strategy is the best approach to investing. Long-term, it has led to healthy results with less risk of loss than more active investing approaches. It is certainly true that investors occasionally beat the market in the short-term. With so many people investing, you would expect a few to do well. In the long term, though, ordinary investors simply cannot consistently beat the market. For the vast majority of us, the best move is to buy and hold stocks for the long term.