Buy and Hold
What it is:
How it works/Example:
Let's assume you have $100,000 to invest. Based on your circumstances, risk aversion, goals, and tax situation, you put $50,000 of the money in stocks, $30,000 in bonds, $10,000 in real estate, and $10,000 in cash. Thus, 50% of the portfolio is in stocks, 30% is in bonds, 10% is in real estate, and 10% is in cash. As time passes, the stocks in the portfolio might rise so much in value that the stock weighting increases from 50% to 70% and consequently reduces the proportion of the other asset classes in the portfolio.
In this situation, the investor might sell some of the stocks or purchase securities in other asset classes in order to bring the portfolio back to the original weighting (this is often called a constant-mix or dynamic strategy). If the investor reweighs the portfolio frequently, say every three months, then the investor is said to engage in market timing, tactical asset allocation, or active investing. In both types of rebalancing approaches, the investor must consider whether the effort and additional transaction costs will increase returns. However, if the investor refrains from rebalancing the portfolio at all, effectively leaving the investments to do what they may, the investor is practicing a true buy and hold strategy.
The buy and hold strategy is not completely passive because unless the investor is purchasing shares of an index fund, he or she must actively select the securities in which to invest. Buy and hold investors commonly rely on fundamental analysis of the company behind a security, such as the company's long-term growth strategy, the quality of its products, or the company's relationships with management when deciding whether to buy or sell. However, short-term fluctuations, business cycles, inflation, and responses to new legislation do not influence the buy-and-hold investor.
The active investor, on the other hand, often uses quantitative and technical analysis, including ratio analysis, stock chart analysis, and other mathematical measures to determine whether to buy or sell. The active investor's investment horizon can be months, days, or even hours or minutes.
Why it matters:
There are several reasons that Warren Buffett and other successful investors favor the buy and hold strategy.
First, many investors espouse the random walk theory which states that securities prices are random and not influenced by past events. Princeton economics professor Burton G. Malkiel coined the term in his 1973 book A Random Walk Down Wall Street. The idea is also referred to as the weak form efficient-market hypothesis. The central idea behind the theory is that it is impossible to consistently outperform the market, particularly in the short term, making a buy-and-hold investing strategy the best way to maximize returns.
Second, many experts believe that what an investor buys or sells is more important than when he or she buys or sells it. Because many asset classes tend to rise and fall together, a portfolio's overall return is much more affected by how the portfolio is allocated rather than the specific securities chosen. A well-known 1986 study by Brinson, Hood, and Beebower confirmed that 95% of the time, asset allocation determined a portfolio's returns rather than the specific securities chosen.
Third, the buy and hold strategy is often cheaper. It can have tax benefits since the IRS taxes long-term capital gains at a lower rate than short-term capital gains. Also, the strategy requires less in trading commissions and advisory fees, which often force active investors to have higher return requirements to compensate for these extra costs.