Capitals markets, namely debt and equity, are the primary routes by which companies are able to raise long-term capital. However, they are often extremely volatile over short periods of time, causing investors to overreact and become irrational. The intelligent investor is able to harness his or her emotions and make sound decisions that are consistent with the business fundamentals present in the marketplace.
A stock share is an ownership claim on the cash flows of a public company. These shares are traded on stock markets, which are discounting mechanisms that are constantly valuing stocks at different prices. While a stock's price may demonstrate extreme volatility over a day, week, month or even year, the stock market is like a casino game rigged towards the players. Investing with a conservative, passive strategy is sure to yield satisfactory results.
In the United States, the Dow Jones Industrial Average (DJIA) yielded an annualized 7.0% total real return from 1950-2009. As opposed to the nominal return, real return is adjusted for inflation, reflecting aggregate price changes that transpired during the time period. Moreover, total return assumes that all dividends are reinvested, a critical aspect of maximizing return. It sounds easy to make money, doesn't it? Well, yes and no.
It is important to note that the DJIA historical return is an average of the yearly total return. Over relatively short time periods, the stock market has dropped in value by massive amounts, such as a 27% loss from 1981 to 1982 or 49% loss from 2000 to 2001. Fortunately, these bear markets are offset by bull markets of greater magnitude. For example, the great bull market of the 1990s yielded a 14.7% total real return. Only investors with prolonged time horizons for their investments are sure to weather this kind of extreme volatility.
Properly diversifying is crucial when seeking to minimize the risk of an equity portfolio, especially in the modern financial world. Beta, a variable that describes the systematic risk of a security or portfolio in comparison to the market as a whole, has never been higher between the U.S. and international markets. In other words, markets around the world are more interconnected than ever before because of globalization. Shocks to a financial system in one nation can imply serious implications to economies globally. Thus, keeping beta low through an internationally diversified portfolio is critical to the buy-and-hold investor.
Another important buy-and-holding investment strategy is indexing. Indexing is investing in index funds, or equity funds that are intended to represent an index. As indexes are often correlated with the economic health of a region or industry (such as SPDR S&P 500), an index fund investor is almost guaranteed to see returns over long periods of time.
Index investing is also a traditional way of diversifying a portfolio. While individual stocks are likely to fluctuate many percentage points over short periods of time, since most index funds are diversified, their volatility is reduced substantially compared to a stock's. An index fund's yield is not likely to be as high as a given individual stock's, but this comes at a sizably reduced risk. Accordingly, indexing is a crucial aspect for investors subscribing to a conservative, buy-and-hold strategy.
Holding Your Position
It's been said that an investor's greatest enemy is himself. Humans often attribute more weight to their emotions than rational thought. Accordingly, an investor can easily lose sight of his or her logical, methodical investing strategies if some financial calamity takes place. When a stock's price is appreciating, an investor is emotionally driven to buy, just as when a stock's price is depreciating, an investor is emotionally driven to sell. However, these are the worst times to enter and exit the market. Instead of buying low and selling high, the mantra of any successful market player, human emotional responses naturally condition investors to enter the market before the crashes and exit the market before recoveries.
A truly great investor is able to ignore what his emotions are telling him. With an investment time horizon of many years, the worst thing a buy-and-hold investor can do is realize his losses by liquidating his equity position. Stay the course, investing in business fundamentals at the right price.
Another time tested buy-and-holding investment strategy is portfolio rebalancing. To rebalance one's portfolio, an investor first sets the percentages of his portfolio allocations to what he thinks is best suited for each different investment vehicle. Of course, these percentages are different for every investor based on his investment personality, such as his liquidity needs, time horizon and relative suitability.
Now for the actual rebalancing. Take for example the classic portfolio structure is 50% stocks and 50% bonds. Every few months or so, an investor can sell off stock and buy bonds, or buy stock and sell bonds to reach these pre-determined percentages. Thus, an investor can ensure that he or she is not caught up in market speculation. If the prices of stocks rise to meteoric heights, a sell signal is triggered and the investor will realize these capital gains. If the stock market plummets, a buy signal goes off and the investor enjoys extremely discounted stock prices. As you can see, portfolio rebalancing is a method of ensuring that the buy-and-hold investor is not caught up in speculative crazes.
The Bottom Line
Buy-and-hold investing is not for the faint of heart. It can be extremely unsettling for an investor to stand by as the value of his or her portfolio erodes. The buy-and-hold investment strategy requires investors to disregard their emotional responses to market movements. If these investors can resist their emotional temptations, they can achieve outstanding success. Of course, while buy-and-holding investing has seen some success since the inception of the stock market, past investment performance is not indicative of future returns.