Saturday, April 23, 2011

Passive Investing: Buy And Hold

Buy and hold investment strategies are exactly  what the name says. You buy some stocks, and never sell it! Rather than trading regularly securities are purchased and held for a long period of time (usually many years).

The greatest advantage of buy and hold strategies is that of passive investment: low cost. Brokers commissions, spreads and other dealing costs become occasional rather than frequent.

Buy and hold strategies are not necessarily passive or mechanical, although many are. A buy and hold investor may actively select investments, but hold investments once bought, and review a portfolio with a view to buying and selling relatively infrequently.

The thinking behind a purely passive buy and hold strategy is that of other passive strategies, with, perhaps, a greater emphasis on minimising costs — unlike passive strategies such as index tracking that require constant re-balancing.

More active buy and hold strategies usually rely on the assumption that it is possible to select mispriced securities (usually shares), implying that markets are not efficient, but that these mispricings will be corrected in the long term.

Passive investing

Passive investing is the opposite of active investing. It is often taken to be synonymous with index tracking. However there are many other passive strategies, such as buy and hold strategies — especially mechanical ones.

The strongest argument in favour of passive investing is that the market is efficient, and therefore efforts to beat the market are likely to achieve little more than increase costs. It is also inevitable that at least as many active investors will under-perform the market as will out-perform. Trying to beat the market is a zero sum game.

This means that it is possible to argue for passive investing even if the market is not efficient, because most investors will under-perform the market.

Given that the average investor will perform in line with the market, index tracking offers the advantages of lower volatility, and much lower costs. Tracker fund charges are much lower than those of active fund managers.

It is sometimes argued that by allocating assets to the largest companies, exposes investors too much to the largest sectors. Although a different allocation might give a lower volatility, it will do so at the expense of returns, because the market portfolio is on the efficient frontier. A better strategy for controlling risk would be to move along the capital markets line by buying risk free assets.

The reason for this might be clearer if you consider the CAPM. Sectors that have a heavy market weighting will have a higher correlation with the performance of the market. They will therefore have a higher beta, and their future returns will be more heavily discounted. Therefore such sectors will have higher expected returns.

1 comment:

  1. Thanks for the article. I like a Buy-and-Hold-Plus. This is almost as passive as real passive investing and is a long term approach. It combines Buy-and-Hold with Index Investing and Trend Investing/Following: buy low cost index funds and hold them until the long-term market trend start going down. Buy then again when objective long-term trend signals indicate that the trend is up again. Success.

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