Buy and Hold Trading Strategy — What Is It? (Backtest)

Last Updated on August 28, 2022 by Oddmund Groette

If you have ever looked at a stock chart, you would know that stock prices often swing about, which is why some people trade the swings for quick profits rather than wait out the inevitable downturns. However, most stocks rise exponentially over the long term, which is why investors like the buy-and-hold strategy. But what is the buy-and-hold strategy?

The buy-and-hold strategy is a long-term investing approach that involves buying stocks and not selling them for many years (even decades) only selling a few portions when you need to raise money. This strategy does not care about the short-term peaks and valleys in stocks but, rather, tries to make the most of the long-term potential of stocks — the fact that many stocks continue to rise over time. The strategy is in contrast to active trading, where traders try to time the market by buying when prices are low and selling when prices are high to lock in profits.

Let’s take a look at this investing method to know the merits

Buy and hold definition

The buy-and-hold strategy, also called position trading or long-term investing, is a passive approach to investing that involves buying stocks and not selling them for many years (even decades) — the investor only sells a few portions when they need to raise money. This strategy does not care about the short-term peaks and valleys in stocks but, rather, tries to make the most of the long-term potential of stocks — the fact that many stocks continue to rise over time. In other words, buy-and-hold investors simply select the stocks to invest in, build their portfolio, and ignore the short-term price movements, knowing that over many years, the stocks would have risen several folds.

Buy and hold is in contrast to active trading, where traders try to time the market by buying when prices are low and selling when prices are high to lock in profits. Here, an investor buys stock — or other types of securities such as ETFs — and holds them for a long period regardless of fluctuations in the market. Warren Buffett and many other legends of Wall Street speak highly of the buy-and-hold approach. In fact, studies have shown that buy and hold investors, on average, tend to outperform active management over longer time horizons and after fees; moreover, they can typically defer capital gains taxes. However, critics of the approach argue that buy-and-hold investors may not sell at optimal times.

Understanding how the buy-and-hold strategy works

The buy-and-hold strategy works in a very simple manner: the investor simply selects a stock or an ETF, invests in it, and keeps it for many years, or even decades, depending on when they need the money. It is essentially a long-term approach to investing. How long the investor holds depends on why they are investing — if the investment is planned for retirement, for example, they may hold it for decades until retirement when they would need the money.

Compared to active trading, the buy and hold approach is in line with the Efficient Market Hypothesis (EMH), which states that all known information about investment securities (stocks, in this case) is already factored into the prices. According to the EMH, no one can beat the market over the long run with their skills or research, but by buying and holding, one’s investment can grow along with the market.

The buy-and-hold strategy can be implemented with any style of investing. A growth investor can spot a stock with huge growth potential and buy it. They would hold the stock until it has grown significantly — buying into Amazon in 1997 would have been a great buy-and-hold growth play. Similarly, an investor who believes in value investing can use the buy-and-hold approach. They can find undervalued stocks buy them and hold them until their P/E ratios show that the stocks are significantly overvalued and then sell them.

Building a stock portfolio

Of course, the buy and hold principle can be applied to buying individual stocks, whether you want to buy a single stock or build a portfolio of stocks. It is often better to have a portfolio of many stocks from different sectors so as to stay diversified and reduce risks. When building a portfolio, you have to actively research and select the stocks you want to invest in. After that, you allocate your capital among the selected stocks, buy them, and then forget about them. You ignore the short-term fluctuations in the market and be ready to hold through market crashes. In the long run, most of the stocks would have risen multiple folds.

A more passive way to implement the buy-and-hold strategy while having a diversified portfolio is to invest in a mutual fund or an exchange-traded fund (ETF). An ETF or mutual fund is already a diversified portfolio of stocks. You simply buy and hold for as long as you want. Since the stock market increases in value over time, your investment will grow along with the market.

Is buying and holding a good strategy?

You may be wondering whether buying and holding is a good strategy and if it is superior to an active trading strategy. Both experience and study reports have shown that over a long period, buy and hold yields a better return than most active traders. There are many reasons for that, including the difficulty in timing the market, but one key reason is that buy and hold has tax benefits, as the investor can defer capital gains taxes on long-term investments.

Moreover, buying shares of common stock is to partake in the ownership of a company, and ownership has its privileges, such as voting rights and a stake in corporate profits as the company grows. As a shareholder, you can be a direct decision maker with your votes — your number of votes is equal to the number of shares they hold — deciding critical issues, such as mergers and acquisitions and the election or appointment of directors to the board. So, instead of treating ownership as a short-term vehicle for profit in the mode of a day trader, as a buy-and-hold investor, you keep your shares through bull and bear markets. While you bear the ultimate risk of failure, you get to enjoy the supreme reward of both dividends and huge price appreciation.

Talking of huge price appreciation, let’s say you invested $1,000 in Amazon (AMZN) in 2021. You could have purchased 67.84 shares of Amazon.com at the time with $1,000. This investment in AMZN would have produced an average annual return of 30.88%, and you would have approximately $218,793.08 today. That is over 20,000% returns, and you would have made over 200 times your initial investment over a period of 20 years. Similarly, if you had invested in Apple at $18 per share in 2008, you would have made over 900% in returns in 10 years (2008 to 2018).

In summary, while there are arguments against using a buy-and-hold strategy, especially the claim that investors forsake gains by riding out volatility rather than locking in gains and miss out on timing the market, evidence shows that buy and hold is a good strategy if you invest in the right stocks. Apart from the gains, investment success also comes from loyalty, commitment to ownership, and the simple pursuit of standing pat or not moving from a chosen position.

Why buy and hold?

Buy-and-hold investors typically make stock purchase decisions based on long-term investment theses about the companies of interest, and as long as an investment thesis remains intact, the buy-and-hold investor continues to own the company’s shares.

But why buy and hold? The reason is pretty simple: the buy-and-hold strategy is easy to execute; probably the easiest form of investing — all you have to do is buy a stock or group of stocks and not sell them. But there are things you must do to get it right.

As a buy-and-hold investor, you must prioritize buying shares of companies with strong business fundamentals. You should be more concerned with how a company is being run than with short-term changes in the stock price because as long as the company’s business continues to grow and perform well, the stock will keep rising.

But this doesn’t mean you shouldn’t pay attention to price at all. It is important to pay attention to price while buying, as overpaying for anything can result in not enough value being generated to justify the price paid. You may consider buying value stocks, which trade below the prices that their business fundamentals suggest they’re worth, if you are a value investor. If you prefer growth investing, then, focus on growth stocks — companies that are increasing their revenues and profits by pursuing attractive business opportunities.

Benefits of buy and hold strategy

There are many benefits of the buy and hold strategy, but these are the most common ones:

Cost saving

By holding your stocks for longer periods, you trade less often and thus incur less trading costs. This can positively affect the net return of your portfolio. Another way it saves cost, even if your broker doesn’t charge trade commissions, is by deferring taxes on capital gains and getting taxed at the favorable long-term capital gains rate. Any investment that is held and sold for a period greater than a year is eligible to be taxed at a long-term rate, which is lower than the short-term rate used for investments held under one year.

Risk reduction

The buy-and-hold strategy is a passive investing approach, so it reduces what is called “manager risk — the risk of human error associated with active trading or actively managing a portfolio.

Less stressful

Buy-and-hold is less stressful to implement compared to active trading and saves a lot of time. It is a simple approach. Just like buying a house, you identify the stocks to buy, invest in them, and just let the investment do its thing, without having to worry about trying to find the “perfect” entries and exits or checking the price incessantly.

Buy and hold blends well with dollar-cost averaging and index fund investing. You don’t need to do much research to build a portfolio on these strategies. You can even automate the process and save more time.

Buy and hold vs. trading

Here is how buy and hold compares with trading:

  • Unlike trading which requires you to cut losses short, minimize risk, and maintain a steady return, buy and hold investing requires you to tolerate huge drawdowns. During the great recession in 2008/09, the S&P 500 fell by 55%, which buy and hold investors had to bear.
  • Buy and hold investing is not flexible, but short-term trading is both flexible and scalable. As a trader, if you manage to find profitable strategies, you can scale it by automating the process to make money when you are not there or increasing your position sizes via leverage. However, excessive use of leverage may be disastrous.
  • Because trading is scalable and offers the opportunity to frequently turn around your capital, you can get wealthy much faster than by long-term investing. You can apply the power of compounding to make more money faster with trading.
  • Trading can be exciting but can also be addictive. Long-term investing, on the other hand, is mainly about holding your assets and waiting for appreciation, not very exciting.

Disadvantages of buy and hold strategy

These are some of the disadvantages of the buy and hold strategy:

  • It comes with principal risk: As with any stock investment, buy and hod comes with principal risk, which implies that there’s no guarantee that your money will be there when you need it. It is possible for the stock price to fall after you invest and never recover, so you end up losing some of your principal (initial investment).
  • There is no flexibility: A buy-and-hold strategy always seeks to buy and hold the investment through bulls and bears. If you invest just before a bear market, you will have to wait for the market to recover while active trades can trade in any direction they want and make money.
  • There is price risk: With a buy and hold strategy, you are less concerned about the stock prices, which could leave you more vulnerable to buying stocks when they’re costly, and selling them when they’re cheap.

Buy and hold trading strategy (backtest and example)

A backtest of a buy and hold trading strategy is coming soon.

Similar Posts