Investors employ a number of strategies to try to obtain a return from the financial markets. The “Buy and Hold” strategy is probably the most well-known, as it has proven its effectiveness time and time again. In theory, it is simply a matter of buying and holding financial assets in order to take advantage of the long-term upward trend in the stock market or of holding bonds until maturity. In this article, we will discuss what the “Buy and Hold” strategy actually consists of, detailing the various advantages and disadvantages associated with it. We will contrast this strategy with that of market timing to examine the differences between these two investment strategies. Finally, we will conclude by explaining how one could maximize the return of the “Buy and Hold” strategy.
What is the “Buy and Hold” strategy?
The “Buy and Hold” strategy involves regularly purchasing stocks and bonds (primarily) in order to hold them for several decades to benefit from the economic growth of companies (upward growth over 10, 20, or 30 years for all S&P 500 companies) or to allow the bonds to mature. In short, this strategy requires no in-depth knowledge of the financial markets, as it simply requires a deposit into a basket of more or less studied assets. There are three key points to understand when considering a buy and hold strategy.
A Long-Term Investment Horizon
The key to the “Buy and Hold” investment strategy lies in its duration. S&P 500 stocks offer an annualized return of 11.82% per year over the period 1928-2021. Indeed, although there can be significant disparities in returns over time, the stock market is, on average, bullish. Companies that issue shares become increasingly profitable over the years and therefore increase their net income, allowing them to allocate this new cash to other productive investment projects that will further strengthen their net income (the snowball effect). Companies are therefore, on average, more highly valued, alongside stocks.
To visualize the importance of the notion of time in investing, one only needs to look at the curve of the S&P 500 since the 1980s to understand how exponential the progression of the 500 largest American companies is.
A Large or Regular Deposit
To develop a buy-and-hold strategy, you need to know your available liquidity. In some cases, investors will have the option to make a large deposit at a given time, and they will simply need to hold onto these assets from that point on. In the most common case, investors do not have much liquidity and will need to make regular deposits (in the form of dollar-cost averaging or DCA) into the basket of assets they wish to hold. Generally, according to a study by FactSet, a multinational financial data management company, investing a large amount at the outset will offer a better return than a regular deposit. However, the return on a regular deposit remains excellent and provides greater peace of mind.
As the chart above shows, representing the different returns depending on how one decides to invest their money during the period 1928-2013: investing immediately and holding these assets offers an average return of 12.2%. Here, we are talking about the performance of the S&P500. Investing in the form of a dollar cost average (regular deposits each month) offers a return of 8.1%, while the return of holding 3-month government bonds is 3.6% per year.
A Defined Basket of Assets
Buy and hold, fine, but what? There is no exact answer to this question, as it depends on a lot of investor-specific factors (risk aversion, conviction in certain companies, willingness to hold bonds or not, moral and ethical constraints). It is therefore important to inform yourself about what is possible, what you want, and what is recommended. In reality, ETFs inherently fulfill these characteristics; they allow for strong diversification by providing the opportunity to invest in the 500 largest US companies, some in very different sectors (example of an S&P ETF). Stock picking: the investor’s choice to invest in 5 or 10 specific stocks after in-depth analysis with the aim of “beating the market” can also be a solution, although this practice is recognized as less profitable than regular investment in a simple ETF.
In conclusion, it is important to define the core assets of our investment and the resulting allocation. This is an example of assets that could be at the heart of a “buy and hold” strategy.
In this example, we have decided to invest 70% in an ETF that tracks the performance of the S&P 500 and will be the cornerstone of our portfolio. We have also decided to invest 25% in a bond ETF to maximize the diversification of our portfolio and hold an asset uncorrelated to stocks. Finally, we have decided to invest 5% each month in Bitcoin, which is increasingly establishing itself as a consistent store of value.
What are the advantages of the “Buy and Hold” strategy?
As we’ve already briefly mentioned, the “Buy and Hold” strategy is particularly popular with investors given the many benefits it offers. It allows investors to follow the natural direction of the market, take advantage of compound interest, optimize fees, benefit from tax advantages, enjoy peace of mind, and enjoy a stable return that exceeds many investment funds.
Follow the Market
The stock market (alongside the index market) is on average bullish over the long term. As explained previously, companies tend to increase their revenue and net income over the years, and their stock prices rise accordingly. The money accumulated through profits generated by stocks comes from the work of employees and projects that have led to increased results within a company. It is therefore natural for the market to rise, and with it, for stocks to rise. We previously saw how much the S&P 500 has grown over the past 40 years.
Taking Advantage of Compound Interest
The “Buy and Hold” strategy is partly based on compound interest, which it places at the heart of the strategy. Investing for the long term allows you to best optimize this compound interest phenomenon. Indeed, achieving a 10% return for two consecutive years is very different from achieving a 20% return in two years. Let’s take an example:
At a given time, I deposit €1,000 into two different stocks (A and B):
– Fund A offered me a return of 10% in the first year and 10% in the second year.
– Fund B offered me a return of 0% in the first year and 20% in the second year.
You might think that the final return of these two companies is equivalent, but this is where compound interest comes into play. Let’s calculate the performance of these two funds.
– The first year in Fund A increased my portfolio to €1,100. (10% of 1,000 = 100)
– The first year in Fund B had no impact on the value of my portfolio.
– The second year in Fund A increased my portfolio to €1,210. (10% of 1,100 = 110)
– The second year in Fund B increased my portfolio to €1,200. (20% of 1,000 = 200)
When this phenomenon is spread out over time, the compound interest the investor receives becomes increasingly important and becomes a key component of the “buy and hold” strategy. Furthermore, reinvesting the dividends earned allows for maximum optimization of this compound interest phenomenon.
Optimize stock market fees and take advantage of tax benefits
In a “buy and hold” strategy, withdrawals are kept to a minimum, and the only fees the investor pays come from the buy orders they place on the financial markets. By avoiding recurring sales of assets, losses related to stock market fees are greatly limited; transaction costs are said to be reduced. There is no strategy that minimizes fees as much as the “buy and hold” strategy.
The “buy and hold” strategy also offers certain tax advantages thanks to the longevity of the investments. Indeed, most investors use a PEA (share savings plan) to invest for the long term, and after holding assets for 5 years, gains are exempt from income tax (12.8%). However, they are still subject to the flat-rate withholding tax of 17.2%.
Stable Performance Over Time
Buying and holding financial assets like stocks for long periods of time has an impact on their performance. The difference in return variation is negatively correlated with the length of time the asset is held. In other words, the longer the asset is held, the less spaced-out the return expectations are; conversely, if the asset is held for a short time, the return possibilities are very wide. To understand this phenomenon, let’s look at the graph below provided by SchwabCenter for Financial Research.
As you can see, buying a stock and holding it for one year will offer a performance between 54.0% and -43.3%, while holding it for 20 years will offer a performance between 17.9% and 3.1%. After the 20th year of holding, in theory, negative performance can no longer be achieved. The results of these graphs should be taken with a grain of salt, but it explains particularly well the disparities in performance depending on the length of time the assets are held.
An average return higher than investment funds
A buy-and-hold strategy offers a higher return than over 90% of investment funds that try in vain to beat the market. When we talk about “beating the market,” we mean achieving a performance higher than that of the S&P 500 over a year. In reality, beating the market is extremely complicated, because market anomalies from which one can profit are arbitraged at unimaginable speeds. According to the efficient markets hypothesis, the price reflects the information available on the market, and each piece of information is immediately incorporated into the price, with no possibility of profiting from it.
In conclusion, and this is what Eugène Fama explained in financial market theory, the best thing to do in the stock market is to buy and hold these assets. There is no point in trying to beat the market by any means.
Peace of mind
Buying and holding assets offers unparalleled peace of mind. Obviously, we must assume that we are taking a step back from our investment. Investors have no need to monitor stock prices; the only time to start paying attention to stock prices is when they decide to sell their shares, after several decades. Regular deposits without taking into account the information we hear drastically reduce impulsive decisions driven by feelings. Generally speaking, buying and holding financial assets is a mechanical strategy in which feelings play little role, which is its strength. Obviously, each person is different, and the relationship to feelings in the financial markets varies from one individual to another.
What are the disadvantages of the “buy and hold” strategy?
While the “buy and hold” strategy offers many of the advantages we’ve discussed above, it also has (like any strategy) its weaknesses and disadvantages. It requires a certain amount of psychological bias to be aware of. Furthermore, the investment is very long-term and, in some cases, requires regular rebalancing.
Addressing Psychological Biases
In this section, we’ll discuss the four psychological aspects you need to master to ensure the success of your long-term financial asset purchase and holding plan: patience, boredom, social proof, and fear.
Be patient
The strategy we’ve been discussing since the beginning of this article is based on compound interest, which is itself maximized by the length of time an asset is held. In other words, the longer you hold an investment, the more the interest it generates increases. However, for some investors, it’s difficult, if not inconceivable, to invest money for 20-30 years. In a connected and fast-paced world where households are increasingly driven to consume, and where life in general is more dynamic, it’s more difficult to consider long-term investments, especially when they require a significant portion of income.
Overcoming Boredom
For an investor who wants to be active, buying and holding assets for a long period of time can seem particularly boring. Some are willing to reduce the return on their investments in order to actively manage their assets, to experience the adrenaline rush one can feel when trading in the financial markets. However, these feelings are far removed from the very concept of investing: maximizing profit while minimizing risk. It is therefore essential to prioritize this investment strategy, without paying it excessive attention.
Social Proof
Human beings adopt behaviors aimed at gaining validation from other individuals by appearing attractive to others. When it comes to financial markets, the desire to highlight performance resulting from well-thought-out financial decisions by selling stocks before a market crash or buying them at a market low can lead investors to deviate from their intended investment plan. By buying and holding your financial assets, your financial decisions may not be impressive, but your performance will be superior to 99% of the people who will talk to you about the stock market.
Control your fear
When investing over long periods, financial markets experience both positive and negative events, and everything that happens in the world can have a greater or lesser impact on the market value of the financial assets you hold. There may be wars or other types of geopolitical conflicts (2023-2024), there may be periods of strong growth, there may be global pandemics like in 2020, or economic and financial crises like in 2008-2009, or in 2010-2012 in Europe. Markets can react unexpectedly and significantly to these types of events. Sometimes stock prices drop drastically, and you need to know how to control your fear so as not to sell these stocks when everyone else is doing so. Adhering to the basic investment plan will always be the best solution; we must take advantage of certain “catastrophic” moments to understand the opportunities that present themselves.
It is often when many investment funds and individuals abandon the financial markets that prices suddenly rebound. Therefore, we must demonstrate resilience and patience when the market experiences a period of weakness.
I felt it was essential to discuss the buy-and-hold strategy because, although it may seem basic, it remains a profitable approach, despite its appearance as a beginner’s strategy. It is ideal for entering the world of financial markets and perfectly combines simplicity with performance. It is also a strategy that offers comfort and peace of mind. I believe I have covered the important concepts related to this strategy. I hope you enjoyed the article; please leave a comment if you did, and thank you for reading.