Investor Warren Buffett once famously said, “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.”
Buffett was describing the buy-and-hold investment strategy. The idea is for investors to research companies before buying shares only in the ones they believe will thrive for the long term.
This passive investment strategy has been used by countless people to build wealth, but what exactly is it, and should you use it in your investment portfolio?
What Is the Buy-and-Hold Investment Strategy?
The buy-and-hold strategy is an investment strategy centered around thoroughly researching a stock, buying it, and holding it for a long period of time regardless of its short-term price fluctuations.
With enough research and fundamental analysis, investors should be able to determine whether the company is successful and likely to maintain that success over the next decade or more. Once you’re confident the company is a strong buy, you purchase the stock and pretty much forget about it.
Over the course of a long-term investment, buy-and-hold investors pay little attention to short-term volatility, remaining confident that their original research will lead to a long-term win.
Because of the set-it-and-forget-it nature of buy-and-hold investing, following this strategy is considered passive investing. However, passive doesn’t necessarily mean no work is involved. For this strategy to work out well, investors must put in significant due diligence in the beginning and rebalance their portfolios at least once annually.
There are two ways to go about building a buy-and-hold investment portfolio, either through researching and purchasing individual investments or buying shares of investment-grade funds like exchange-traded funds (ETFs), mutual funds, and index funds.
How the Buy-and-Hold Investment Strategy Works
Here are the steps to employing this strategy:
Step #1: Determine How You’d Like to Invest
Start by determining how you’d like to go about investing: by purchasing individual stocks, bonds, and other assets, or by purchasing investment-grade funds.
Keep in mind that while there’s more work involved in choosing individual assets, doing so gives you the most control over your money.
Step #2: Choose Your Investments
This step will be different for those choosing individual investments and those investing in funds. Here’s how each works:
When choosing individual investments, research is the name of the game. Think of stocks and bonds that might represent the type of companies you’re interested in owning. Then, thoroughly research the fundamentals of each company
During this fundamental analysis, pay close attention to the following:
- The Company’s Current and Historical Success. How successful is the company at the moment? Since you’re buying assets to hold for the long term, it’s important to invest in companies that have achieved a high level of success and are likely to continue to do so. Is the company one of the strongest in its category? Is it profitable? Is it generating substantial revenue?
- Economic Moat. Only invest in companies with an economic moat. This is a term Buffett uses to describe competitive advantages like patents and proprietary supply chains that stop competitors from offering the same products.
- Financial Standing. Determine how strong the company is from a financial perspective by digging into its balance sheet. Even profitable companies are often funded by debt, which could be a recipe for disaster. Make sure you’re not investing in companies following that recipe.
- Management. A company is only as strong as its management team. Look into who’s running the company and their history as executives, both where they are now and at the companies they helped to lead in the past. Is the team one you want at the helm of a company you own?
- Valuation. Although short-term fluctuations aren’t important to buy-and-hold investors, it is important that you purchase stock at a fair valuation. Using metrics like the price-to-earnings (P/E) ratio, PEG ratio, and price-to-book value ratio, compare the stock to others in its category and make sure you’re paying a fair stock price when buying shares.
Investment Grade Funds
When choosing investment-grade funds, you’re letting the fund managers do the work for you, but it’s still important to compare your options. Closely consider the following:
- Historic Performance. Although historic performance isn’t always indicative of future long-term returns, it’s a good measure of how successful the fund manager has been over time. Look at the rate of returns over the past five to 10 years to get an idea of what you can expect ahead.
- Expense Ratio. Investment-grade funds come with an annual cost outlined as an expense ratio, or the percentage of your investment dollars you’ll pay each year to invest in the fund. Make sure you pay the lowest expense ratios possible because high expenses cut into your profits.
- Passively Managed. Actively managed funds don’t generally buy and hold assets for a long period of time. As such, it’s important that the funds you choose are passively managed, increasing the holding periods of assets in the portfolio. This will help reduce your tax burden on these investments while allowing you to stick to your strategy of holding assets for the long run.
Step #3: Buy
Using your favorite brokerage account, purchase the stocks and bonds that you’ve decided have the most potential to generate meaningful long-term returns. If you’re not already working with an online broker, it’s time to start looking around at some of the best brokers online.
Keep in mind that timing is everything in the stock market. You don’t want to buy on highs just before a correction. One of the best ways to time your buy-and-hold investments is through a gradual process called dollar-cost averaging, which involves making multiple equal investments over a period of time to ensure you don’t buy in at the top.
A common way to buy in gradually is to invest a portion of every paycheck or make automated contributions toward your investments every month or quarter.
Step #4: Hold
Sometimes the hardest part of using a buy-and-hold strategy is the holding. Markets go up and down all the time. A little market volatility is enough to send some types of investors racing for the exit.
Buy-and-hold investors who have done their research are holding investments they expect to pay off years down the road, not necessarily this week. Resist the urge to watch the markets every day, because the short-term price fluctuations don’t really matter to you until you decide it’s time to sell your investments.
Step #5: Rebalance Occasionally
A healthy investment portfolio is one with proper asset allocation, but over time, some assets will move at different rates than others, creating an imbalance. When this happens, your portfolio will either become overexposed to risk or underexposed to potential returns.
To avoid this issue, investors should rebalance their portfolios at least once annually. Many investors rebalance semi-annually, quarterly, or even monthly.
Pros and Cons of the Buy-and-Hold Investment Strategy
As with any other strategy for accessing the market, there are pros and cons to consider if you’re thinking about becoming a buy-and-hold investor.
Pros of the Buy-and-Hold Strategy
Some of the biggest perks to using this strategy include:
1. A Common-Sense Approach
Rather than using intricate technical analysis in an attempt to exploit market volatility, the buy-and-hold strategy takes a more common-sense approach. The goal is to find companies that are successful and likely to maintain their success over time.
You won’t need complex math, a detailed understanding of technical indicators, or the expertise to find patterns in a chart when taking this approach to investing.
2. Low Taxes on Capital Gains
Any time you make money in the United States, the IRS wants its cut. That cut is smaller on gains from investments held for a year or more than it is on gains from short-term investments.
According to the IRS, most investors will pay long-term capital gains taxes of no more than 15%. High-income earners will pay a maximum of 20%. However, short-term capital gains are considered standard income, taxed at the standard income tax rate, which caps out at 37%, according to the Tax Foundation.
3. No Need for Market Timing
You’ll be holding your investments for several years, during which time peaks and valleys will happen. So, there’s no point in trying to time the market to find the best entry point. Instead, buy-and-hold investors are better served using dollar-cost averaging to average their entry cost over a period of time.
4. Reasonable Returns
Finally, those that take research seriously at the beginning of this strategy have the potential to yield significant long-term returns. While you’re not going to get rich anytime soon using the buy-and-hold strategy, it is a compelling recipe for building wealth over time.
Cons of the Buy-and-Hold Strategy
Sure, there are plenty of reasons to follow this strategy, but there are a few drawbacks.
1. Potentially Lower Returns
Passive investing comes with lower levels of risk, but also a lower potential return than active investing. Those with a higher risk tolerance who want to outpace overall market returns are generally better served as active investors.
2. Hard to Hold Through Bear Markets
Following this strategy means you should hold your investments regardless of market conditions. This can lead to painful declines during bear markets that take some time to recover from.
3. Time to Profitability
Buy-and-hold investments are made for the long term with little concern for short-term growth. As a result, these investments may take a while to pay off, and in some cases, may never reach profitability.
Is Buy-and-Hold Investing Right for You?
The question of whether buy-and-hold investing is the best option for your portfolio is impossible to answer without knowing more about you. Everyone has a unique tolerance for risk, goals, and financial circumstances.
Buy-and-hold investing might be best for you if:
- You Are Risk-Averse. This strategy tends to focus on steady, stable companies with a proven record of success, making it a strong option for risk-averse investors.
- You Are Patient. This strategy is a slow-growth option. Although you won’t get rich overnight, it is a tried-and-true way for a patient investor to build wealth over the long run.
- You Are Busy. Although there is some upfront work involved in this strategy, once your investments are set up, there’s really not much left to do. That makes buy-and-hold a perfect strategy for people who don’t have the time or desire to constantly check in on markets and the companies they invest in.
The buy-and-hold strategy is a compelling way for patient and risk-averse investors to capture the wealth-building power of financial markets. If you choose to follow this strategy, keep in mind that research will be the foundation of your success.
Take the time to get to know each investment before throwing your hard-earned money into the ring, and you’ll be pleasantly surprised with the long-term results.