A Simple Guide to Buy and Hold Investing

Buy & Hold investment strategy is based on the view that financial markets provide good returns on investment over longer periods of time despite their short-term volatility. A Buy & Hold investor actively selects good quality investments, but once they are bought, is not concerned with short-term price movements.

Buy & Hold strategy is based on the idea that markets are remarkably efficient in digesting and adjusting to new information. When new information arises about a particular stock or market as a whole, that information is generally reflected in market prices without delay. Therefore, the theory goes that markets have a tendency to correct themselves if given enough time. If markets are beaten down due to fear, sooner or later optimism will ensue and markets will correct themselves back up. If markets are drastically up due to too much optimism, they will eventually correct themselves by shrinking. In other words, what goes up eventually comes down, and, what goes down eventually comes up.

This type of behavior is also known as reversion to the mean, which is a statistical phenomenon stating that the greater the deviation of the market from its mean, the greater the probability that it will deviate less far next time around. In other words, rapid market upswings are always followed by rapid market downturns. The faster markets move up, the rapid their downward movement will be.

A reason to Buy & Hold is that broader stock markets (such as S&P 500 Index) have provided compounded annual growth rate of return (CAGR) of 7.47%.

[caption id="attachment_188" align="alignright" width="300"] S&P 500 Historical Performance from 1950-2012[/caption]

The S&P 500 Index began tracking markets some 62 years ago. The S&P 500 Index opened at 16.66 on January 2, 1950. The S&P 500 Index has closed on October 15, 2012 at 1440. The CAGR during this 62 year period is 7.47%.

The CAGR during the last 30 years ranging from 1982 through 2012 is 8.58%.

Either way you slice and dice it, you can see why holding your investments over long periods of time provides ROI that would not be able to get otherwise through savings, treasury bills, bonds, real estate, commodities, or any other investment vehicle.

So, the question really is how do you make Buy & Hold approach to your advantage?

The answer is quite simple. You build a diversified portfolio of high quality, low-cost index mutual funds. The most diversified portfolio is the one that covers entire gamut of domestic and international markets. As such, you can build portfolio of mutual funds targeting value, growth, small, large, domestic, international, real estate, and bonds. Depending on your risk tolerance and the number of years left to retire, it is important to hold a certain portion of your investment as bonds. In my own case, I have a target of 75% stocks, and 25% bonds and other income producing assets.

Also, another question that arises in investors’ mind is that there are so many choices. How and which funds do I choose?

If you are totally new and just starting out with a small sum of money, my recommendation is to choose a Target Date Retirement Fund. My favorite investment company is Vanguard, but most other firms also offer similar funds. Choose the fund that matches the year in which you will retire. The Target Date Funds typically invest in multiple funds and automatically changes its stocks and bonds allocation as your retirement date nears. In other words, it becomes more conservative as you approach retirement.

If you have at least $12,000, then invest in these 4 funds. These four funds pretty much cover the entire gamut of financial markets. Plus, these funds will give you finer control on asset allocation. Lastly, if your investment reach 10,000 or higher in each of these funds, you’ll be charged less costs by Vanguard.

Total Stock Market Index Fund
Total International Stock Market Index Fund
REIT Index Fund
Total Bond Market Fund

I have put together a set of portfolios from all major providers. Click recommended portfolios for more information.

How shall I invest – all at once or in small portions at regular intervals?

I have seen people argue both ways. But, I recommend that you invest in one or few funds with minimum fund investment requirements. And then, set up daily, weekly, or monthly automatic contributions. This is what I do for my incremental investments.

Buy & Hold is too simple. Where is the fun?

If you like emotional roller coaster, then Buy & Hold is NOT for you. Buy & Hold will not provide you with morning jolts. You buy funds, set them on auto-pilot, and forget it. That’s all. But, main advantage of this strategy is that your emotions are not involved in decision making. These decisions are made automatically for you. You keep buying funds when it is emotionally harder to buy during downturns and you buy less funds automatically when markets are upbeat.

If Buy & Hold is so great, why isn’t everyone doing it?

In the wake of the great recession of 2008-2009, many investors believe that the Buy & Hold approach has become outdated. Diversification no longer worked, they argue, because all asset classes moved up and down together, especially when stock markets fell. In other words, diversification failed them us just when it was needed. I can certainly understand these sentiments.

Many people who make these statements now are making them after the fact. When the stock market was on the upswing, many people took more risk than they could digest. They invested heavily in emerging markets, which are much more volatile. Many people invested in actively managed funds where portfolio managers too greater risks to achieve higher returns. Lastly, many people bought investments when they were at the peak and sold them out in panic when they bottomed out. So, it is no surprise that many of these people lost more than people who were diversified.

Also, since Buy & Hold is simple and involves low-cost index funds, this is exactly why the financially industry and community doesn’t like it. It gets less and less talked about on CNBC. Financial advisors don’t make money when people DIY using this simple strategy.

Regardless of how people are behaving, I have decided not to follow the herd. I believe in this approach. It is based on sound financial principles. So, I am going all in without any doubts.