We can debate whether buy and hold is a more effective method than other investment strategies, but it has two major advantages that are beyond any doubt. One is that transaction fees are generally lower with buy and hold than with other more active investment approaches. The second, which is even more significant, 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 ensures that your capital gains will be of the more favorable, long-term variety, and with much less frequency.
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 purchase and when you sell (even with $0 commission, you are still paying bid-ask spread and other regulatory fees). 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 your return on stocks held for an extended period will exceed those of active traders who incur a lot of transaction fees and create frequent taxable gains.
The 1% difference that has a significant effect on the outcome
With so many discount investment brokers offering such low or $0 transaction fees, it’s easy to ignore the effect of those fees on long term investment returns. 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 30 years, earning an average annual return of 8% using buy and hold, you would 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 2020, a long-term capital gain will result in zero tax liability for a taxpayer whose income is below $40,000 (or $80,000 for a married couple) — on the other hand, the short-term capital gain tax rates could be as high as 22%.
The long-term capital gain tax rate increases to 15% of single people with income between $40,001 and $441,500 (or a married couple with income between $80,001 to $496,600). Finally, the tax rate maxed out at 20% for high-income earners. On the other hand, the short-term capital gain tax rate can be as high as 37%!
It is clear that the negative impact of short-term capital gains tax is significant compared to the long-term capital gains tax of buy and hold.
Funds Can Be Buy and Hold Oriented
The buy and hold investment strategy is not limited to stocks. You can invest in mutual funds and exchange-traded funds (ETFs) that use the same investment strategy.
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 smaller 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?