Buy and Hold Strategy Explained

As investors, we're faced with the choice to buy and hold the stocks we've selected, or actively trade these securities.   The buy and hold strategy is a passive investment technique in which investors continue to hold onto their stocks, regardless of market conditions.  It's an interesting approach, with some market theory to back it up; but the effectiveness of the strategy is worth exploring too.  

In this publication, we're going to explain the topic of buy and hold, as it applies to the stock market.  As part of that discussion, we'll briefly explain the technique of buy and hold, and why it's followed by some investors.  Next, we'll talk about the historical returns provided by this investment strategy.  Finally, we'll finish up with a summary of the advantages and disadvantages of buy and hold.

Buy and Hold Technique

The theory behind the buy and hold technique goes something like this:

It's impossible to consistently achieve above average returns, on a risk-adjusted basis, according to the efficient market hypothesis (EMH).  Investors have access to information that will fairly value a security at all times.  Therefore, it is pointless to make decisions that might result in the active trading of a security.

Investors that believe in the above theory would have no reason to actively trade the stocks in their portfolio.  The buy and hold technique is a long-term investment strategy.  If the market went down in the near-term, that's an acceptable outcome.  The longer-term trend should be a positive one.

Followers of the buy and hold strategy also believe the technique is very efficient in terms of fees and commissions.  At the extreme, stocks are purchased and only sold when money is needed by the investor, thereby minimizing brokerage commissions.

In addition to lowering costs and ignoring short-term declines, subscribers to the buy and hold technique also believe it's impossible for the average investor to "time the market."  Since stocks are fairly priced, attempting to "buy low and sell high" is a waste of time.  It is much easier to buy a stock and hold onto it over the long haul.

Historical Returns:  Buy and Hold

At the extreme, a buy and hold investor would never sell shares of their stocks.  If the market declined sharply, they would merely wait for the market to eventually bounce back.  To evaluate the historical investment returns for the buy and hold strategy, we looked at a leading stock market indicator over relatively long periods of time.  The results of that analysis appear in the table below:

Average Annual Return: Buy and Hold

The above table looks at the performance of the S&P 500 Index over the fifty year timeframe from 1960 until 2010.  The information in the above table is read this way:

• Example 1:  From 1960 until 1970, the S&P 500 provided an average annual return of 5.8%.
• Example 2:  From 1960 until 2010, the S&P 500 provided an average annual return of 36.8%.
• Example 3:  From 1970 until 1990, the S&P 500 provided an average annual return of 14.1%.

Using the performance of the S&P 500 Index over relatively long periods of time, we can see the longer-term returns the buy and hold strategy provides investors.  We can also see the variability in those returns.  For example, an investor that adopted this strategy back in 1960 would have realized an average annual return on investment of 36.8% over a 50 year timeline.  On the other hand, an investor adopting this strategy in 2000 would have seen a loss of 2.1% per year over ten years.

Advantages and Disadvantages: Buy and Hold

We started this topic with a brief overview of the buy and hold strategy, and why it's used by some investors.  Next, we provided insights into the historical annual returns associated with buying and holding stocks by examining the long-term results of the S&P 500 Index.  In this final section, we'll be discussing the pros and cons of the technique:

Advantages

• Ease of Implementation - since the technique involves the one-time selection and purchase of stocks, it's an easy strategy to adopt.  Once the stock portfolio is assembled, there is no need to monitor stock prices over time, or worry about short-term market fluctuations.
• Eliminates Poor Timing Decisions - some investors try to "time the market," attempting to predict when a bear market has bottomed out, or a bull market has run its course.   Buying and holding stocks eliminates the possibility of making a series of poor timing decisions.
• Efficiency - sales commissions / brokerage fees are lower, since the total number of transactions will be minimized.
• Income Taxes - long term capital gains are taxed at a lower rate than short-term capital gains.

Disadvantages

• Unlimited Losses - since the technique calls for holding onto stocks regardless of price signals or news, there is no limit on the possible losses.  For example, despite warnings that a company may be on the verge of bankruptcy or facing a financial crisis, the investor would continue to hold the shares of stock until they were worthless; thereby losing the entire investment.
• Risk Tolerance - during severe market downturns, the investor may eventually panic and sell all their shares of stock.  Investors need to have high risk tolerance scores to avoid "buying high, and selling low."

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