What is Buy and Hold Investing?

Skip the backgrounder and find out here - Is Buy and Hold Dead?

I just got off the phone with my sister who is brand new to trading. I couldn’t be more thrilled about the chance to share my passion & knowledge about trading with someone close to me. Naturally she’s full of questions and you can tell she’s doing her homework. It’s nice for me in the way that being able to succinctly explain a concept also tests and reinforces my own understanding.

Listening to her questions, I can tell she’s building a framework in her own mind about finance & markets. I hope over the long term I can foster the kinds of insight and further curiosity that will have her calling herself a trader some day soon. So she asked me to help her understand buy and hold as a practical strategy and any purported benefits. As she posed her question, I attempted to grasp a perspective just how many people must have lost untold fortunes over the last year from buy and hold, the strategy among strategies when your goal is moderate growth and relative safety. It is so easy for me to argue against it despite it’s obvious merits, given that the year earlier has been so terrible for many investors relying solely on this strategy.

The rules of buy and hold are simple, just like it sounds. Investors using buy and hold basically set up a budget for buying a pre-determined stock or basket of stocks at some frequency. When the time comes whether monthly, quarterly or some other schedule - the investor buys as many shares at the market price as their budget will allow.  There are well understood benefits to the buy and hold strategy.

One such beneficial aspect of buy and hold is what is known as dollar cost averaging. Because the investor buys on some regular basis, they are less likely to buy during highs or lows as often and so they normally end up buying near the average price. The net effect is that they end up with a higher value asset purchased at the average cost.

Another way the buy and hold investor can benefit is by compounding. As a stock increases in value it generates earnings for the investor who adds the new earnings right back into the investment. At this point the investor begins earning based on their inital investment plus the new earnings. Over time new earnings generated by compounding can generate earnings that easily outpace the earnings gained from increases in the value of the underlying investment. An added benefit of some stocks is that earn aquarterly or biannual per share dividend. The dividends are also reinvested in the form of either more shares or simply held as cash in the investment account where it will add to the interest earnings and compounding. This reinvesting of dividends is  referred to a DRIP or a Dividend Reinvestment Plan.

An example of compounding at work (reprinted from Investopedia www.investopedia.com)

 

Compound Interest from Buy and Hold Investment Strategy

 Investopedia explains Compounding
 

Suppose you invest $10,000 into Cory’s Tequila Company (ticker: CTC). The first year, the shares rises 20%. Your investment is now worth $12,000. Based on good performance, you hold the stock. In Year 2, the shares appreciate another 20%. Therefore, your $12,000 grows to $14,400. Rather than your shares appreciating an additional $2,000 (20%) like they did in the first year, they appreciate an additional $400, because the $2,000 you gained in the first year grew by 20% too. If you extrapolate the process out, the numbers can start to get very big as your previous earnings start to provide returns. In fact, $10,000 invested at 20% annually for 25 years would grow to nearly $1,000,000 (and that’s without adding any money to the investment)!

 
Now that we all know the basic strategy behind buy and hold there’s one thing left to consider. One last little curve ball… Buy and hold only works when markets are trending up. Many novice investors would have done well over the last 52 weeks had they known this integral bit of info. You see, when the value of the underlying stock is steadily declining, the buy and hold investor continually pays the highest price for the stock, the value of the investment never exceeds the initial investment and the interest earned is always less than before due to the continual erosion of value of the underlying security. It’s a losing battle and many people have lost fortunes blindly following buy and hold way longer than they should have. I get a sense that when it comes to their investments (401k’s, IRA’s and the like) a suprising number of people simply ignore their duty to stop the bleeding when the market sours. Why? I suppose it’s because many feel that managing their retirement is at best a mysterious art or perhaps buy and hold was over sold to them and they never had a full understanding of this simple form of investing.

Now what do I tell my sister? Maybe I could tell her to look at her 401k and decide if buy and hold is right for her. Chances are she won’t be happy. Ideally she’ll understand that it does have it’s place as a viable strategy. That it is to be employed under the right conditions, not just ANY conditions - as so many people seem to believe.

As long as she understands buy and hold has its share of shortcomings, I wouldn’t mind telling her that many analysts seem to think the market’s put in a bottom and that buy and hold can be a decent strategy as long as she intends to pay attention to the market.

I think she’ll know what to do. Finally, our original subject…

Is Buy and Hold Dead?

I know this has been a long read and I appreciate you sticking with me. Now heres a chance to stop reading and just relax. I found this timely video from my friend Adam Hewison (lead analyst over at INO.com).

Here’s Adam’s opinion of Buy and Hold and a perfect place for me to end this article. Adam describes our current market environment and shows us how he’s decided once and for all… Is Buy and Hold Dead? Launch the Video