Buy & Hold
The buy & hold investing strategy is a passive approach in which investors purchase securities and hold them for the long-term, regardless of market volatility. A buy & hold portfolio of low-cost total market index funds coupled with dollar cost averaging is a strategy that is hard to beat. For most investors who simply want to earn stock market returns and not worry about the details, this is a good strategy to use.
Before investing, investors need to assess their risk tolerance. Investors can do so by taking this investor questionnaire to determine their recommended target asset allocation.
Asset allocation is the percentage of stocks, bonds and cash that you hold in your portfolio. Your asset allocation impacts the volatility / risk of your portfolio. The most critical decision you can make that affects the outcome of your investment strategy is defining your target asset allocation. A 100% stock portfolio usually provides the highest returns over time; however, it comes at the expense of high short-term price volatility and has the possibility of significant losses. A 100% cash portfolio typically provides the highest safety for your money in exchange for the lowest returns over time. A mixture of stocks, bonds and cash usually reduces volatility and provides investors the capability of rebalancing when your portfolio's actual asset allocation deviates from your target asset allocation. A 60% stock / 40% bond portfolio is a very popular asset allocation for getting decent returns with lower volatility / risk.
There are thousands of investment choices available to investors, from individual stocks / bonds to mutual funds / ETFs (Exchange Traded Funds), real estate, commodities, derivative securities, and more. This list of choices is overwhelming, and new investors can be consumed with "analysis paralysis" trying to decide the best investment for themselves. Fortunately, there are low-cost total market index funds available that allow investors to earn the market return with minimal expenses. These funds provide a convenient way for investors to participate in the market without the need for in-depth analysis or the complexities of selecting individual securities.
When you watch the news, you'll often hear the words "the stock market was up or down today" usually followed by quotes of the S&P 500, Dow Jones Industrial Average or NASDAQ Composite Index. The S&P 500 Index is a collection of the 500 most valuable public companies traded on U.S. stock exchanges. The S&P 500 Index has been collecting data since 1957, and financial academic researchers have reconstructed historical data going back to the 1870s. The Dow Jones Industrial Average is a price-weighted average of 30 prominent companies representing various sectors of the US stock market. The NASDAQ Composite Index includes most companies listed on the NASDAQ stock exchange. The list of companies in the S&P 500 and the Dow are adjusted periodically by committee as individual companies are added and removed from each respective index. These three stock market indices are among the most closely monitored in the United States.
A stock index is essentially a mathematical calculation derived from the prices of all the individual stocks included in the index, excluding transaction costs. While it's not possible for investors to invest directly in a stock index, mutual funds and ETFs have been created which invest in a statistical sampling of the underlying companies tracked by an index. A well managed index fund closely mirrors the mathematical index if follows.
Some index funds offer very low costs and there are even a handful of zero cost funds that track major indexes. This provides investors with an efficient and cost-effective way to gain exposure to a broad range of stocks without the complexities and transaction costs associated with purchasing individual stocks.
While past performance is no guarantee of future performance, total market indexes have outperformed individual stocks over the long term because individual companies rise and fall over the long term while the overall market endures.
Investors generally seek to receive the highest possible returns from the market; however, it is not possible to predict ahead of time which security will perform the best on any given day. Recent past performance is also not a good indicator of which stocks will outperform on any given day. As a group, market participants have a limited amount of money to invest and in order for one investor to profit $1 another investor has to invest that $1. Companies generate profits and can either distribute a portion of those profits to shareholders via dividends or reinvest profits in the company. Corporate profits are what drive long-term growth in the stock market.
Individual stocks have the potential to provide the highest returns, however this usually comes with the highest risk of daily price volatility. Since the future is unknowable, it is not possible to reliably predict which company investors will flock to causing their share price to increase, or which company investors will flee from causing their share price to decrease. Rather than wasting time trying to pick the winners and the losers, you can simply purchase a low-cost total stock market index fund such as the Vanguard Total Stock Market Index ETF (VTI).
While index funds provide average returns of the overall stock market on a daily basis, these returns are based on the combined return of all the companies in the market index which tends to trend upward over the long term. As individual companies come and go, the market index endures and provides the easiest method to capture the returns of the overall stock market.
Active vs. Passive
Mutual funds were created to mitigate the risk of individual companies failing by investing in multiple companies that meet the investment criteria of the fund. Funds can be actively or passively managed. Active management involves a fund manager deciding which stocks to buy and sell while passive management simply buys all stocks that meet the investment objectives of the index fund. Passive funds have lower expenses than active funds because there is less overhead and lower expenses translates to better returns.
It is trivial for an individual stock to beat the market index on a daily basis. After all, the market index is simply the average of the day’s returns. However, after ten years, low-cost total stock market index funds have historically beaten most of the competition. As indexing is getting more popular (50% of market is now held in indexed products) it seems like the time it takes for an index strategy to outperform an active strategy is getting shorter. My litmus test for any stock equity fund is to backtest past performance against VTSAX and see which one outperformed historically. I know past performance is no indication of future performance, however it is usually a good indicator to compare two financial products over the same time period.
Some investors think that active investing can give them an edge in order to beat the market. Below are strategies that have occurred in the past and will eventually happen again:
- Growth stocks can outperform value stocks over time.
- Value stocks can outperform growth stocks over time.
- Small and mid-cap stocks have a lot more growth potential than large caps because of their size.
- Individual sectors can outperform the market over time.
- International stocks can outperform US stocks over time.
- US stocks can outperform international stocks over time.
- Emerging market stocks can outperform US stocks over time.
Unfortunately, it’s impossible to predict which of these strategies will come to fruition during your investment time horizon, and it has historically been very difficult to outperform the stock market over long time periods. Rather than try to predict the winner, for most investors it's generally easier to simply invest in a low-cost total stock market index fund.
Don't try to find the needle in the haystack. Just buy the haystack. John C. Bogle
If you feel so inclined as to dip your toe into active investing in an attempt to outperform the market, you can tilt your portfolio towards a certain sector, individual stock, asset class or active mutual fund by investing a small portion of your portfolio in the investment of your choice. Keeping your investment small limits your risk should you choose a strategy that underperforms the market.
Rather than investing in individual stocks, you can consider actively investing in passive index funds that include the company or sector you are interested in. In this way, you are using passive index funds as building blocks to actively manage your portfolio.
Dollar Cost Averaging
Saving for retirement is a lifelong goal. We are born with no money and must earn and save / invest enough during our working years to sustain us after we are no longer able or willing to work. The easiest time to invest is when you have extra money. The hardest time to invest is when you don't. It is recommended you invest when things are easy than when they are hard.
Q When is the best time to invest? |
A When you have money
There are a few common sources of money to use for investing:
- employment income
- dividends & capital gains
The starting point for investing is to pay yourself first. This means saving a percentage of your income and transferring it to a separate investment account each time you get paid. This is called dollar cost averaging. If you invest 10-15% of your income for 30-40 years in low-cost total market index funds, you should have a comfortable retirement. If you cannot afford to save 10% of your income when you start investing, it's ok to start with a smaller percentage. The most important thing you can do is get started. As your income increases and as you are able you can increase your savings rate.
The secret of getting ahead is getting started. Mark Twain
Some investors are the beneficiaries of inheritances and receive a lump sum of money. This windfall can be a small or large sum of money. It is generally advantageous to invest a lump sum of money right away to get the best returns, however this can create feelings of buyer's remorse should your investment go down immediately. To mitigate these feelings, you can invest the lump sum in two or three different chunks on different dates. If the market goes up after your first investment, you will be grateful for that investment. If the market goes down after your first investment, you will be grateful for your second investment. The ultimate use of an inheritance is a personal decision, however if you want to make a portion of it last a lifetime you will need to invest it according to your investment strategy.
The best source of money for investing is capital gains and dividends. Your ultimate goal is to make your money work for you as a replacement for you working for your money. It takes a lifetime of saving and investing to meet this goal in retirement. Once your investment income exceeds your spending you reach financial independence.
Dollar cost averaging works by investing automatically according to your investment strategy at regular intervals. Because markets are always moving, DCA allows you to buy shares at different prices allowing you to pay the average price for your investments. In the short term market prices fluctuate regularly as illustrated by the daily price movement of the S&P 500 for the past two months below:
Over longer time periods volatility still exists; however, a general upward trend starts to emerge as illustrated by the monthly price movements of the S&P 500 for the past two years below:
Over decades market volatility has historically eased and a general upward trend is visible as illustrated by the yearly price movement of the S&P 500 for the past two decades below:
Buy & hold strategy with low-cost total market index funds is hard to beat
Low maintenance to rebalance portfolio periodically if desired, no need to constantly monitor
Periods of volatility and must have fortitude to Stay the course
Cookie cutter portfolio is not appealing to some investors
Long only portfolio (i.e. no way to profit in declining market)