Portfolio Toolbox
buy & hold

Buy & Hold

The buy & hold investing strategy is a passive strategy in which investors buy securities and hold them for the long-term regardless of volatility in the markets. A buy & hold portfolio of low cost total market index funds coupled with dollar cost averaging is a strategy that is difficult to beat. For the vast majority of investors who simply want to earn stock market returns and not worry about the details, this is the 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

Asset allocation is the percentage of stocks, bonds and cash that you hold in your portfolio. Your asset allocation determines the volatility / risk of your portfolio. The most important decision you can make that affects the outcome of your investment strategy is to determine 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 to lose the most amount of money. A 100% cash portfolio typically provides the highest safety for your money in exchange for the 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 good returns with lower volatility / risk.

Investment Universe

There are thousands of investment choices available to investors, from individual stocks / bonds to mutual funds / ETFs (Exchange Traded Funds), real estate, commodities and derivative securities, etc. This list of choices is overwhelming and a beginning investor can be consumed with analysis paralysis trying to decide the best investment. Fortunately there are low cost total market index funds available that allow an investor to earn the market return for a minimal amount of expense.

When you watch the news you will eventually hear the words "the stock market is up or down today" usually followed by quotes of the S&P 500, Dow Jones Industrial Average or NASDAQ Composite Index for the day. 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 started collecting data in 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 from different 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 the most followed in the United States.

A stock index is simply a mathematical calculation of the prices of all of the individual stocks contained in the index that excludes transaction costs. While it is not possible 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 and a good index fund tracks its mathematical index very closely. Some of these funds have very low costs and there are even a handful of zero cost funds that track the major indexes.

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.

Asset Selection

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 companies investors will flock to causing their share price to increase or which companies 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 of 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:

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:

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 buyers 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 the 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:

Analysis

ProsCons
  • 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)