buy-and-hold investing vs. market timing

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Buy-And-Hold Investing Vs. Market Timing

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By Investopedia.com | 11.12.2012

If you were to ask 10 people what long-term investing meant to them, you might get 10 different answers. Some may say 10 to 20 years, while others may consider five years to be a long-term investment. Individuals might have a shorter concept of long term, while institutions may perceive long term to mean a time far out in the future. This variation in interpretations can lead to variable investment styles.

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For investors in the stock market, it is a general rule to assume that long-term assets should not be needed in the three- to five-year range. This provides a cushion of time to allow for markets to carry through their normal cycles. However, what's even more important than how you define long term is how you design the strategy you use to make long-term investments. This means deciding between passive and active management.

Long-Term Strategies

Investors have different styles of investing, but they can basically be divided into two camps: active management and passive management. Buy-and-hold strategies - in which the investor may use an active strategy to select securities or funds but then lock them in to hold them long term - are generally considered to be passive in nature. Figure 1 shows the potential benefits of holding positions for longer periods of time. According to research conducted by Charles Schwab Company in 2012, between 1926 and 2011, a 20-year holding period never produced a negative result.

Source: Schwab Center for Financial Research

Figure 1: Range of S&P 500 returns, 1926-2011

This is some very compelling data to convince investors to stay in for the long run.

Active Management

On the opposite side of the spectrum, numerous active management techniques allow you to shuffle assets and allocations around in an attempt to increase overall returns. There is, however, a strategy that combines a little active management with the passive style. A simple way to look at this combination of strategies is to think of a backyard garden. While you may plant different crops for different results, you will always take the time to cultivate the crops to ensure a successful harvest. Similarly, a portfolio can be cultivated along the way without taking on a time-consuming or potentially risky active strategy.

A good example of this method would be in tax management for taxable investors. For example, a security or fund may have an unrealized tax loss that would benefit the holder in a specific tax year. In this case, it would be advantageous to capture that loss to offset gains by replacing it with a similar asset, as per IRS rules. Other examples of advantageous transactions include capturing a gain, reinvesting cash from income and making allocation adjustments according to age.

Timing

When it comes to market timing, there are many people for it and many people against it. The biggest proponents of market timing are the companies that claim to be able to successfully time the market. However, while there are firms that have proved to be successful at timing the market, they tend to move in and out of the spotlight, while long-term investors like Peter Lynch and Warren Buffett tend to be remembered for their styles. Figure 2 below shows returns from 1996 to 2011.

Source: Schwab Center for Financial Research

Figure 2: S&P 500, 1996-2011

This is probably one of the most commonly presented charts by proponents of passive investing and even asset managers (equity mutual funds) who use static allocation, but manage actively inside that range. What this data suggests is that timing the market successfully is very difficult because returns are often concentrated in very short time frames. Also, if you aren't invested in the market on its top days, it can ruin your returns because a large portion of gains for the entire year might occur in one day.

The Bottom Line

If volatility and investors' emotions were removed completely from the investment process, it is clear that passive, long-term (20 years or more) investing without any attempts to time the market would be the superior choice. In reality, however, just like with a garden, a portfolio can be cultivated without compromising its passive nature. Historically, there have been some obvious dramatic turns in the market that have provided opportunities for investors to cash in or buy in. Taking cues from large updrafts and downdrafts, one could have significantly increased overall returns, and as with all opportunities in the past, hindsight is always 20/20.