The Key Advantages of Buy and Hold Investing

We can debate whether buy-and-hold is a more effective method than other investment strategies, but it has two advantages that are beyond question. One is that transaction fees are generally lower with buy-and-hold than with other more active investment approaches. The second, which is even bigger, is the long-term capital gains tax benefit.

Both of these expenses can cut deep into investment returns over the long-run, and buy and hold is one of the best investment strategies to keep them to a minimum. You buy a stock, hold it for several years, and that prevents transaction fees from being imposed on the same money every year as they are when stocks are actively traded. And it insures that your capital gains will be of the more favorable, long-term variety, and with much less frequency.

telescope

Photo via Wikimedia Commons.

Buy and Hold Improves Return

Buy and hold is just what it says — you buy a stock and hold it for many years. You pay a fee when you buy and when you sell. In the years in between when you’re merely holding the stock, you’re incurring no fees. If the stock also pays generous dividends, it’s a sweet combination of annual return and an absence of fees.

You can hold on to the stock for as long as you like, and when the price reaches your target level, you can sell and collect a handsome gain — on top of the returns that you were earning while you were holding the stock.

That increases the likelihood that you’re return on stocks held for a long period of time will exceed those of active traders who incur a lot of transaction fees and create frequent taxable gains.

The 1% difference that has a major effect on the final outcome

With so many discount investment brokers offering such low transaction fees, it’s easy to ignore the effect of those fees on long term investment return. It’s only a small amount with each trade, however those small amounts can make a big difference in the long run.

If you had $25,000 to invest over a period of 30 years, earning an average annual return of 8% using buy and hold, you will have $369,364 at the end of that period (we’re ignoring income tax consequences for simplicity sake).

But let but let’s say that by using a more active trading strategy you incur an average of 1% per year in additional transaction fees. Instead of being 8%, your average annual rate of return is effectively 7% after deducting the additional fees. The same amount of money invested over 30 years would produce only $190,306.

That’s a difference of nearly $180,000 just because of a 1% difference in transaction fees!

The long-term capital gains rate

Even if you have an active trading strategy that enables you to get higher returns than you can with a buy-and-hold strategy, you still may not do as well. Active trading strategies lead to short-term capital gains. These gains are taxed at your regular rate of taxation — or more particularly, the highest rate. By contrast, buy and hold creates long-term capital gains, which get favorable tax treatment.

For 2012, a long-term capital gain will result in zero tax liability for a taxpayer whose top tax rate is 15% or less. A short-term capital gain of the same amount could result in a tax on the gain of either 10% or 15%.

At higher income levels, a long-term capital gain would reach a maximum of 15% of the gain, while a short-term gain on the same amount would reach 25% to 35%.

It’s virtually impossible to calculate the negative impact high short-term capital gains rates will have on short-term trading strategies as compared to the long-term capital gains advantage of buy and hold.

Funds Can Be Buy and Hold Oriented

The choice is not limited to buy and hold of your own stocks; you can invest in mutual funds and exchange traded funds that use the same investment strategy. That can be the best of all worlds.

Funds with a low turnover ratio, say 20-30% are by definition buy and hold funds. This is because a 20% turnover ratio indicates that the typical stock in the fund has been held for five years. That’s comparable to what you would do with your own buy-and-hold strategy. It might even be advantageous to hold stocks in a low turnover fund since you’ll not only pay low turnover fees — probably lower than what you’d pay if you built your own portfolio — but you’d also have professional management.

And since the individual stocks are held long-term, you’ll also get the benefit of long-term capital gains rates. Lower transaction fees, and lower income tax consequences. That’s a hard combination for a short-term investment strategy to beat.

Are you mostly a buy and hold kind of investor, or do you favor short-term trading strategies?

About the Author

By , on Nov 20, 2012
Kevin Mercadante
Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

Best Low Cost Stock Brokers

Featured Articles

Leave Your Comment (5 Comments)

  1. I agree completely. Buy and hold is something of a permanent strategy (as opposed to a trading system). Your buying in and holding for years. The price you get when you buy is huge. Buy at the top and you could be in negative territory for a very long time. Buy at the bottom and you can move up quickly (and dramatically).

    You shouldn’t attempt buy and hold unless you’re fully prepared to buy in slowly (or not at all) when the market is looking rich, and heavily after a big sell off.

  2. AM Greenwich says:

    With buy and hold I think you have to take into account the timing also matters. Take for example, someone who had entered the market right before the collapse and someone who had brought the stocks after the collapse. I think many people would be quick to sell their portfolio as it decreased in value.

  3. Hi Chad–There’s a lot of merit to what you’ve written. Buy and hold isn’t a lifelong fire-and-forget strategy. It’s more of a buy then hold while the trend holds. And you’re so right, when markets reverse they tend to do so with greater intensity than bull market runs.

    You have to keep your greed instincts under control. If you’ve made money for a few years and the market is looking wobbly, it’s time to begin paring back your holdings. That’s a way of locking in your gains too.

  4. Chad says:

    Since leaving the stockbroker industry there has always been one aspect of buy and hold that really bothers me and that is trend duration. Put simply what takes years to build, takes moments to destroy. That really is the true nature of the market. Look at any chart for any bull market and you will see the same pattern: a long slow uphill climb. It makes everyone feel good and if you think about the market like a football game the time of possession would be solidly in the bull’s favor. HOWEVER, when the bears get there turn they move with extraordinary ferocity. A bear chart looks more like something you would need to repel down. It simply drops off. What I have learned to do is take some money off the table if not entirely when the bull market starts to wane. Bull markets are easy to predict when there in their late stages and a little more difficult to predict when you are about to go over. But for the last few years I have avoided every major downturn in the market and in most cases I have made money while the market goes down (which gives me more capital to work with when prices are lower). Yes I pay more tax, but the tradeoff financially and for my sanity it’s worth it.

  5. Shawn James says:

    Kevin Mercadante, I follow short term trading strategies as I have been testing these strategies and it match with my trading style. However, I have shares of Microsoft and Google and hold it since last two years. As these are good companies and may offer me good profit in long term.

Leave a Reply

Your email address will not be published. Required fields are marked *

*

Disclaimer

The information on this site is strictly the author's opinion. It does NOT constitute financial, legal, or other advice of any kind. You should consult with a certified adviser for advice to your specific circumstances.

While we try to ensure that the information on this site is accurate at the time of publication, information about third party products and services do change without notice. Please visit the official site for up-to-date information.

For additional information, please review our legal disclaimers and privacy policy.

Notice

Moolanomy has affiliate relationships with some companies ("advertisers") and may be compensated if consumers choose to buy or subscribe to a product or service via our links. Our content is not provided or commissioned by our advertisers. Opinions expressed here are author's alone, not those of our advertisers, and have not been reviewed, approved or otherwise endorsed by our advertisers.