LEVEL: BEGINNER
Requiring more diligence than passive investing, the buy and hold strategy is a step-up in difficulty when compared to passive investing but is still considered to be a very simple investing strategy. The buy and hold strategy is, just like it sounds, to buy particular stocks you expect to increase in value over time and hold them in your portfolio as they rise in value. When the stocks reach full valuation, you have achieved the return you desired, or the stock no longer has the same compelling story it had when you bought it, you sell the stock.
Buy and hold investors tend to focus on the fundamental valuation and growth prospects for individual stocks of interest. They pay particular attention to the balance sheet and other financial statements of specific companies. They tend to seek companies with increasing earnings and contained costs. Additionally, they may also seek companies with a competitive advantage in the specific industry and ones that are expected to maintain this advantage over time. A strong brand name and company image is also a good sign for a potential buy and hold investor (Think – Coca Cola, Apple, and Google).
For buy and hold investors of pooled asset securities, ETF’s and mutual funds, the analysis is slightly different. For these investments the investor is looking at the past performance of the portfolio manager and making a meaningful bet they will be able to produce similar results in the future. (Actively managed pooled investments). They will analyze the risk measures of the portfolio versus the market (did the PM make risky bets to achieve the high return), the fees charged by the fund (fees erase the investment performance enjoyed by the investor), and the turnover ratio of the portfolio (did the PM constantly buy and sell new securities). Keen attention will also be paid to the particular securities in the portfolio to ensure that the fund invests in securities that are in line with its stated goals. (If it’s a domestic equities fund, having a majority of the portfolio in international stocks will not be in line with the fund’s investment criteria). In the end, the expectation is that the fund will rise in value in the long run and exceed the performance of the market.
The buy and hold strategy requires an investor that can stomach short term movements and is not swayed by the vicissitudes of the market. There is nothing worse than selling a long term winner too soon only to see it rise drastically in value after you have sold it. Be diligent, follow your strategy and “stay the course”. The basic tenet of the buy and hold investment strategy is that the investor has a long term view on the market. It’s really that simple? Wait, not so fast.
Downsides
For the buy and hold strategy to be successful it requires one little skill that should not be overlooked, the ability to select winning stocks over the long term. This is easier said than done and therefore the task should not be taken lightly. Many investors are able to select stocks in a bull market when the general tide of the market “lifts all boats”. But in sideways markets or bear markets it’s difficult to identify solid stocks that will outperform the markets. Poor security selection is a very important risk to take note of when employing a buy-and-hold strategy.
Another downside to buy-and-hold investing is market timing, which is the specific entry and exit point of an investment. Despite several tools available that attempt to alert an investor when to enter and exit a trade, it is very difficult to accurately predict the high and low of an investment. As a result, a buy-and-hold investor can mitigate this risk by employing dollar-cost-averaging to build positions. Dollar cost averaging is the process of building a position in a stock by consistently buying the same currency amount of the stock ($100) at regular intervals (once per week) regardless of the price of the stock. Accordingly, fewer shares are purchased when the stock is at a high and more shares are purchased when the stock is at a low. This systematic approach to buy-and-hold investing increases the chances of success since it removes emotion from investing and ensures that you do not purchase a large majority of your shares at the highest price for the stock.
Unlike passive investing which involves the use of index funds and ETF’s, which inherently spreads risk across several investments, another downside for buy-and-hold investing is the potential to create a concentrated portfolio thus increasing your overall risk exposure. It is very difficult for an investor to accurately monitor several stocks, mutual funds, or ETF’s. Unlike many professional money managers that have the assistance of a full research teams, a single investor must be mindful of the limitations of their investment universe. Thus with this limitation it is possible to build a portfolio that is highly concentrated in a few stocks, which ultimately drive the performance of the entire portfolio. As stated earlier, if one’s ability to select winning stocks is less-than-stellar, the risk of portfolio concentration increases ten-fold.
The last major downside is directional bias. Investors employing this strategy generally do not use hedging techniques to mitigate portfolio risk. Thus the portfolios are heavily weighted to perform best when the markets are rising. The lack of hedging through the use of short sales and other derivative instruments can make this strategy very risky in bear markets. However, investors are able to avoid other risks that are associated with margin accounts (short sales) and derivatives trading.