Pros and Cons of a Passive Buy and Hold Strategy

There are essentially two ways to make money in the stock market: fast and risky or safe and steady.

While traders adhere to the former paradigm, most investors fall into the latter category. Armed with the mantra of “buy low, sell high,” these investors seek out undervalued stocks and buy them with the intent to hold on to these positions for months, if not years. To them, a company’s strong fundamental characteristics and sound management supersede all the chaos and flux that is inherent in the market, and in time, the stock will reward them with a large return on their capital.

After all, who wouldn’t want to own Apple Inc. (APPL) when it was trading at $6 per share or Netflix, Inc. (NFLX) at $17? If you are a prospective buy-and-hold investor, then read on to learn about the pros and cons of this popular and highly effective strategy.

Pros

Let’s take a look at the numerous advantages of using a buy and hold strategy.

It Works

Quite simply, the buy and hold strategy has been proven time and time again to return exponential gains on invested capital.

A list of the top buy-and-hold practitioners is a veritable who’s-who of the greatest investors of all time. Perhaps some of these names might ring a bell? Warren Buffett, Jack Bogle, John Templeton, Peter Lynch, and of course, Buffett’s mentor and the father of value investing: Benjamin Graham.

OK, so maybe your stock-picking skills are not as refined as these industry titans. That’s alright. Simply place your money into an index tracker fund, such as the SPDR S&P 500 (SPY) exchange-traded fund (ETF), and forget about it for two to three years. The statistics are on your side. From 2010 to 2020, only 24% of actively managed funds outperformed passive funds and you don’t have to shell out your hard-earned dollars on hefty management fees.

Less Time-Consuming

Is a stock chart as foreign to you as a different language? Do you hear the words “head and shoulders” and immediately think of shampoo? Can’t tell the difference between a simple moving average and the relative strength index (RSI)?

Your technical analysis may need some work, or you are just part of the large group of people that simply do not believe in the efficacy of the art. Academics and successful long-term investors alike have pounded the table for years, citing the fallacy of trying to “time” the market. And the stats would concur; studies have shown that markets are incredibly random (and wrought with anomalies).

As concluded by Nobel winner William Sharpe, in the landmark 1975 study, “Likely Gains From Market Timing,” a market-timer would have to be accurate at least 74% of the time to beat the index.

In other words, leave the head-scratching and hair-tearing to the traders. Much like buying a house, buy and holders look at the overall characteristics of the market, the asset, and the possibilities for future growth and just let the investment do its thing, without having to worry about trying to find the “perfect” entries and exits, or checking the price incessantly.

Supported by Facts

Buy and hold, and investing in general, is what is taught in academia and various portfolio management curriculums, because B&H is based almost entirely on fundamental analysis. Unlike its technical counterpart, fundamental analysis has very little room for guesswork.

The balance sheet, income statement, and statement of cash flows are all static and leave no room for subjectivity. Of course, forecasting growth, such as through a discounted cash flow model, has a large degree of subjectivity attached to it. However, comparing and analyzing companies through the ubiquitous price-to-earnings (P/E) or EBITDA multiples leaves nothing to the imagination, and are integral factors in finding good value stocks to hold for the long run. 

Favorable Tax Treatment

Last but not least, buy and hold is great for long-term capital gains. Any investment that is held and sold for a period greater than a year is eligible to be taxed at a more favorable long-term rate, as opposed to a higher short-term rate.

Cons

Ties Up Capital

The biggest drawback of this strategy is the large opportunity cost attached to it. To buy and hold something means you are tied up in that asset for the long haul. Thus, a buy and holder must have the self-discipline to not chase after other investment opportunities during this holding period. This is exceptionally difficult to put into practice, especially if you have picked up a lagging stock. 

Takes Time to See Growth

To add to the last point, buy and hold is also entirely time-intensive. Just because you have held the asset for 10 years, does not mean that you are entitled to a large reward for your time and capital invested.

Case in point: look at the differences in return between a sluggish utility stock and a fast-moving biotech company. However, bear in mind that the opportunity costs associated with a poor pick can be mitigated through diversification or simply buying and holding an index fund. However, for the former, the performance of a portfolio based around a few high fliers can be dragged down by the laggards.

Moreover, there is nothing stopping an investor from mistakenly picking and holding an entire portfolio of duds. For the latter point, index funds have also proven to not be immune to certain events, such as crashes.

Market Crashes

Finally, just because a stock or an index fund has been held for many years, does not mean that it is infallible. While nothing short of the apocalypse will kill off the markets of developed economies completely, crashes do occur from time to time.

In the event of a correction, leading to a prolonged bear market, buy and hold portfolios can lose most if not all their gains. In these circumstances, investors might get overwhelmingly attached to their assets and simply average down in the hopes of a turnaround.

While solid, well-selected stocks can and have bounced back, there are stocks that go down for the count and wipe out a portfolio in the process.

Take the famous case of Enron. Enron was once seen as a darling of Wall Street, whose stock was valued at a high of around $90 per share in mid-2001. After its illegal accounting practices were discovered, by the time the company disbanded the stock fell all the way to $.60 a share.

Furthermore, an investor with significant exposure not just to a single stock but an entire industry that is wiped out due to technological advances or other reasons can shave their portfolio down to nothing without proper diversification.

Again, a buy and holder, just like any other investor or trader, must have a prudent risk management strategy in place or be willing to pull the plug before the losses piled on, which of course, is easier said than done. 

The Bottom Line

Buy and hold remains one of the most popular and proven ways to invest in the stock market. The practitioners of this strategy often do not have to worry about timing the market or basing their decisions on subjective patterns and analysis. However, buy and hold has a large opportunity cost of time and money attached, and investors must act prudently to guard against market crashes and know to cut their losses/ take profits.