Is Buy and Hold Strategy worth it?

In the stock market, there are essentially two ways to generate money: fast and dangerous or safe and steady.

While traders follow the first paradigm, the majority of investors follow the second. These investors, guided by the mantra "buy low, sell high," search out inexpensive stocks and acquire them with the intention of holding them for months, if not years. To them, a company's strong basic traits and competent management outweigh all of the market's turbulence and flux, and the stock will reward them with a substantial return on their investment over time.

Who wouldn't want to own Apple Inc. (APPL) or Netflix, Inc. (NFLX) when they were trading at $6 or $17 per share? If you're thinking about investing in buy-and-hold stocks, keep reading to learn about the advantages and disadvantages of this popular and very effective technique.

Pros

Let's look at some of the benefits of employing a purchase and hold strategy.

It Is Effective

Simply said, the buy and hold approach has been proved to generate exponential returns on invested capital time and time again.

A who's-who of the world's greatest investors can be found on a list of the best buy-and-hold investors. Perhaps some of these names are familiar to you. Warren Buffett, Jack Bogle, John Templeton, Peter Lynch, and, of course, Benjamin Graham, Warren Buffett's mentor and the father of value investing.

Okay, so your stock-picking abilities aren't quite as polished as these industry titans'. It's all right. Simply invest in an index tracker fund, such as the SPDR S&P 500 (SPY) exchange-traded fund (ETF), and leave it alone for two to three years. You have the numbers on your side. Only 24% of actively managed funds beat passive funds from 2010 to 2020, meaning you won't have to spend your hard-earned money on high management fees. 1

Spending Less Time

Is looking at a stock chart as strange to you as learning a new language? Do you think of shampoo when you hear the words "head and shoulders"? Do you have trouble distinguishing between a simple moving average and the relative strength index (RSI)?

Your technical analysis may require improvement, or you may simply be one of the many people who do not believe in the art's efficacy. For years, academics and successful long-term investors have pounded the table, claiming that attempting to "time" the market is a mistake. Studies have demonstrated that markets are very unpredictable, and statistics back this up (and wrought with anomalies).

To beat the index, a market-timer would have to be correct at least 74 percent of the time, according to Nobel Laureate William Sharpe's landmark 1975 paper, "Likely Gains From Market Timing."

To put it another way, leave the scratching of heads and tearing of hair to the traders. Buying and holding companies look at the overall characteristics of the market, the asset, and the potential for future growth, and then let the investment do its thing without having to worry about finding the "perfect" entry and exit points or constantly checking the price, much like buying a house.

Facts back it up

Because B&H is nearly totally focused on fundamental analysis, universities and several portfolio management curriculums teach buy and hold and investing in general. Fundamental analysis, unlike its technical counterpart, allows for very little speculation.

There is no place for subjectivity in the balance sheet, income statement, or statement of cash flows because they are all static. Forecasting growth, such as using a discounted cash flow model, is, of course, subject to a great deal of subjectivity. Comparing and assessing firms using the widely used price-to-earnings (P/E) or EBITDA multiples, on the other hand, leaves nothing to the imagination and is one of the most important elements in identifying solid value stocks to hold for the long term.

Beneficial Tax Treatment

Last but not least, for long-term capital gains, buy and hold is ideal. Any investment kept and sold for a period of more than a year is eligible to be taxed at a lower long-term rate rather than the higher short-term rate.

Cons

Capital is Tied Up

The most significant disadvantage of this method is the high opportunity cost associated with it. Buying and holding an asset suggests you're committed to it for the long term. As a result, a buy-and-hold investor must have the self-control not to pursue other investment options during the holding time. This is really tough to put into reality, particularly if you have a lagging stock.

It Takes Time to Notice Change

To add to the last argument, buying and holding takes a lot of time. Just because you've owned an asset for ten years doesn't mean you're entitled to a hefty payout for your work and money.

Consider the difference between a lethargic utility stock and a fast-moving biotech company in terms of return. Keep in mind, however, that the opportunity costs of a bad investment can be lowered by diversification or just buying and maintaining an index fund. The laggards, on the other hand, can weigh down the performance of a portfolio based on a few high fliers.

Furthermore, there is nothing to prevent an investor from picking and holding an entire portfolio of duds by accident. Index funds have also demonstrated that they are not immune to certain occurrences, including as crashes.

Market Collapses

Finally, just because you've owned a stock or an index fund for a long time doesn't mean it's infallible. While nothing short of the apocalypse can entirely wipe out industrialized economies' stock markets, crashes do happen.

Buy and hold portfolios might lose the majority, if not all, of their gains in the case of a correction that leads to a prolonged bear market. Investors may get overly attached to their investments in these conditions and merely average down in the hopes of a recovery.

While well-chosen stocks can and have recovered, there are stocks that go down for the count and wipe out an entire portfolio.

Take, for example, the Enron scandal. Enron was previously regarded as a Wall Street darling, with its stock reaching a high of over $90 per share in mid-2001. The stock had fallen to $.60 a share by the time the company was disbanded when its fraudulent accounting practices were uncovered. 4

Furthermore, without sufficient diversification, an investor with large exposure to not just a single stock but an entire industry that is wiped out due to technology developments or other factors might slice their portfolio down to nothing.

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

Final Thoughts

One of the most popular and well-proven ways to invest in the stock market is to buy and hold. This strategy's practitioners don't have to worry about market timing or making decisions based on subjective patterns and analyses. Buy and hold, on the other hand, comes with a high opportunity cost in terms of time and money, and investors must exercise caution to avoid market collapses and know when to cut their losses/take profits.