Why buy and hold is the best investing strategy
Buy and hold always beats timing the market
With a volatile market, even experienced investors can find themselves wondering “what if I sold everything and got back in when the market was more stable?” Although it’s tempting, in almost every circumstance it is much better to buy and hold.
I’ll show you some data to prove my point, but the reasoning behind it is actually dead simple. No one is omniscient, and the market is inherently unpredictable. Often, all time highs are followed by further all time highs. One the same token, market lows can sometimes be followed by significantly lower lows. Selling stocks when the market is at an all time high is almost always a recipe for disaster over the long run. Buying stocks at market lows is a better idea, but it is still devilishly hard to time.
Even if someone gets the market timing right, it can still be a really bad idea to go in and out of the market. Capital gains taxes can add up pretty fast. It’s also considerably more stressful to manage an active portfolio. But enough subjective reasoning, let’s take a look at some data.
Looking at the data behind the buy and hold strategy
To look into this further, I used one of my favorite tools: Portfolio Visualizer. It’s a website that publicly hosts resources and tools that used to be available only to wealth managers and financial professionals for a significant fee.
Interestingly enough, one of the tools that is embedded within Portfolio Visualizer is the market timing model. Basically, this lets me use different market timing models, and compare how a portfolio would have performed using the timing model, or as a buy and hold investment (without market timing).
To try this out, I used a relatively simple market timing model based on PE ratios. In this example, the market timing model will shift from stocks to bonds as the PE ratio goes up (which generally indicates stocks are becoming more expensive).
Market timing model based on Shiller PE ratios
PE10 >= 22 - 40% stocks, 60% bonds
14 <= PE10 < 22 - 60% stocks, 40% bonds
PE10 < 14 - 80% stocks, 20% bonds
The balanced 60% stock and 40% bond allocation is used as the benchmark portfolio.
The results: how does a buy and hold portfolio compare to a market timed portfolio
For this example, I am going to take a look at the period over the past 7 years, from 2011 to 2017.
As you can see below, the best investment in this bull market period would have been in the stock portfolio. However, the balanced portfolio (60/40 bonds) also outperformed the timing portfolio.
Now, you may be looking at this and thinking “those are really close, maybe over a longer period the timing would work better?” You’re right! There are definitely periods where the timed portfolio performs better. Below you can see the results for the same portfolio from 2002 to 2017. The timed portfolio returned around $2500 more in this period, which is less than a .5% advantage in CAGR.
So, if the timed portfolio works better, what’s the catch? The timed portfolio performed better only if you don’t take taxes into account. In the time period shown above, the portfolio would shift from stock weighted to bond weighted 6 times. That means that capital gains were taken 2-3 times on a large portion of the stock (or bond) portfolio, easily negating the positive benefit from the market timing model. You can see the shifts below.
Even in the periods where it does work better, market timing will still result in a worse outcome than simply sticking with a buy and hold portfolio.
If timing via a model is a bad idea, market timing “by feel” is suicide
One can always find a model that will deliver outstanding returns looking backward, although as we saw above even a good market timing model is far from a guaranteed success. The bigger issue is market timing “by feel”. When people share with me that they are planning to go out of stocks because the market is too highly valued, or they want to get out before the next crises, I cringe.
It isn’t that I know that they’re wrong - I have no way of knowing if their intuition is correct. But since the market goes up most of the time, when people tell me they are going to sell to avoid a downturn I know that they will be making the wrong decision most of the time. This is the reason why Warren Buffet has been so successful; he buys and holds forever and never lets the market or public sentiment influence his investment strategies. I’d say that’s worked out pretty well for him, and the nice thing is that it can work out equally well for all of us, too.
How to create a great buy and hold portfolio
In addition to Portfolio Visualizer, which I use to backtest my portfolio, I keep track of my investment accounts and allocation through Personal Capital. I’ve used Personal Capital to create a diversified portfolio that I can stand behind through the good times and the bad. Over time, as these investments fluctuate, I can use the allocation advisor within Personal Capital to see where I need to buy more to maintain the allocation I have chosen.
Conclusion: The data speaks for itself… buy and hold wins the day
No matter how you look at it, the best way to guarantee investment gains over the long haul is to buy and hold. Market timing can definitely work, for a time, but taxes and human error easily override whatever potentials gains there may be.