When it comes to the business of investing, there is no shortage of disagreements, and the rise of the ETF industry has added fuel to many of these fires. The active versus passive debate is always a hot topic, but a resolution to this divisive issue is nowhere in sight. A spin-off of this head-to-head battle has also intensified in recent years, as a growing number of investors and advisors have eschewed the traditional buy-and-hold philosophy in favor of “trend following” investing. There is some compelling data in support of trend following as an investment strategy, and the idea of limiting downside losses has some obvious intuitive appeal.
But when it comes right down to it, market timing is a tough game to win. Buy-and-hold has been declared dead on several occasions. But don’t feel bad if you’re a passive investor with a long-term focus. Buy-and-hold has taken some body blows, but this strategy is alive and well. In fact, it’s more important than ever.
Clearing Up Misconceptions
A lot of investors have developed a misconception regarding the idea of buy-and-hold over the past decade, so it is important to clear up that issue first. Buy-and-hold does not mean that investors should pursue a “set it and forget it” strategy; all securities need to be monitored and occasionally rebalanced if their value increases or decreases significantly. So what most investors call “buy-and-hold” would perhaps be more accurately described as “buy, hold, and rebalance.”
The concept is based around buying into quality companies and sticking with them for the long haul, assuming they are able to continually increase their cash flows and improve their businesses in order to remain at fair valuations. If this is done, buy-and-hold strategies are tough to beat by even the most seasoned market timing gurus. Below, we have highlighted three main issues that are bound to creep up on investors following trends as opposed to those who are willing to pursue a less-exciting buy-and-hold strategy.
How Do You Know?
The main problem with trend following is that it is notoriously difficult to accomplish. In a period ranging from July 1, 1982 to June 29, 2007, missing the top ten best performing days of the market would have cost roughly 1.3% a year, or more than $30,000 on an initial $10,000 investment. It is important to remember that these ten days, which dramatically impacted bottom line returns, comprise roughly 0.16% of the total trading days in the period. In other words, you are twice as likely to write a New York Times Best Seller as you are to randomly pick a trading day that will post a top ten return in a 25 year period. So while it would be great to make sure that you were fully invested on these days, it is more or less impossible to predict which of these days will be winners and which will be big losers (unless of course you are very lucky in your decision making).
Taxes and Trading Costs
Another critical component of trend following is the unfavorable tax treatment that comes with buying and selling in the short-term. By buying and selling a security within one year of purchase, investors may have to pay ordinary income tax rates, which can run as high as 35% (and are likely headed higher). On the other hand, investors that hold on to a security for more than a year can pay more favorable long-term rates (which currently top out at 15%). Furthermore, trading costs are also an area that rack up fees and excess costs for investors. While the impact of trading expenses will vary based on the frequency of trading and size of account, these fees have the potential to add up quickly, especially for relatively small investors.
The Dividend Reinvestment Program (commonly referred to as “DRIP”) is one of the greatest advantages for buy-and-hold investors. This program allows investors to reinvest dividends into new shares of the companies or ETFs that made the distribution. Furthermore, this process is usually done free of charge, allowing investors to avoid transaction costs while simultaneously building up their holdings. While the process might seem insignificant, consider this statistic from the Motley Fool; if you had invested $2,000 in Procter & Gamble 30 years ago or $2,000 in Pepsi 20 years ago, your holdings would have grown to $125,000 and $190,000, respectively, simply by reinvesting dividends and nothing more.
Buy-and-hold is admittedly a bit boring, but it’s also effective. It is far simpler and cheaper than market timing, and is a great way for investors to “get rich slowly.” If you’re in it for the long haul, don’t be ashamed to buy, hold, and rebalance.
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Disclosure: no positions at time of writing.