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.
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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?