Embracing Simplicity: The Power of Buy-and-Hold
In the ever-evolving world of investment strategies, it’s easy to get lost amidst the myriad of complex theories and tactics touted by experts. Yet, time and again, history has shown that there’s profound strength in foundational principles. At the heart of these principles lies the concept of buy-and-hold investing. This approach not only champions the virtue of patience but underscores the undeniable power of compound returns.
Complexity obscures the truth. And, many investors are mistakenly adding complexity to their investment portfolios to improve performance. When in fact, the best way to achieve superior results is to embrace simplicity as the following post describes.
Why Simplicity Matters:
- Clarity and Financial Peace of Mind: Simplicity streamlines decision-making processes. This leads to more consistent actions and better results when it comes to investing.
- Improved Performance: Many studies indicate that a simple, consistent approach to investing will lead to enhanced performance over time.
Let Your Profits Run
Did you know that a major reason why index funds outperform many managed funds is their inherent non-rebalancing nature? This is rooted in the Pareto Principle, suggesting that roughly 80% of a portfolio’s return will come from just 20% of the investments.
Consider the intriguing tale of the Coffee Can Portfolio. Decades ago, a successful stock-picker advised his clients to buy promising stocks and essentially forget about them, placing them under their bed in a hypothetical “coffee can”. Such a radical “buy-and-hold” investment strategy rests on the idea that the only way for some holdings to achieve their full potential was to let them grow unchecked.
Coffee Can Portfolio
By the mid-1950s, Robert J Kirby, a reputable stock broker with a stellar track record had a seemingly sound investment philosophy. He routinely advised his clients to shift capital from high-performing, potentially overvalued investments to those that were underperforming and perceived as undervalued. In other words, Kirby embraced the idea of portfolio re-balancing.
However, an enlightening episode demonstrated the potential repercussions of this approach and changed his mind forever.
After a decade-long professional relationship, one of Kirby’s clients experienced the sudden loss of her husband. As she inherited his assets, she expressed her intent to integrate her husband’s account with her own portfolio, which Kirby had been managing. Upon reviewing the husband’s holdings, Kirby found an intriguing pattern. Even though he wasn’t a client of Kirby’s, the husband had discreetly followed Kirby’s investment advice meant for his wife; with a singular deviation. He refrained from ever selling. Instead, he consistently invested around $5,000 in every recommendation Kirby made and securely stored the certificates, letting them mature organically. The husband steadfastly ignored all of Kirby’s sell recommendations. In other words, the husband employed a Coffee Can investment strategy.
This hands-off strategy bore a diverse set of results. Some investments remained modest, valued under $2,000, while others skyrocketed past the $100,000 mark. Most notably, a minor stake in a company named Haloid, which eventually transitioned to the future-iconic Xerox, burgeoned to a staggering value of over $800,000 — dwarfing the total worth of his wife’s entire portfolio.
What Does the Coffee Can Portfolio Teach Us?
- Patience and Long-Term Focus: One of the biggest lessons from the Coffee Can investing strategy is the virtue of patience. By avoiding the urge to actively trade or rebalance, investors can potentially reap the rewards of long-term compound growth.
- Reducing Transaction Costs: Actively managed funds often incur higher transaction costs due to frequent trading. These costs eat into a fund’s returns. The Coffee Can approach, being passive, reduces these costs significantly.
- Avoid Behavioral Mistakes: Frequent trading often results from emotional reactions to market volatility. The Coffee Can approach sidesteps this pitfall, letting rational, long-term decision-making prevail.
Why a Buy-and-Hold Approach is Sound
- Benefit from Compound Growth: By holding investments over the long term, investors can benefit from compound growth, as returns are generated on both the initial investment and the accumulated returns.
- Avoid Timing the Market: Many investors make the mistake of trying to time the market, often buying high and selling low. A buy-and-hold strategy eliminates the risk of poor timing.
- Tax Efficiency: A passive strategy tends to realize fewer capital gains than an active strategy, which can lead to a more tax-efficient return for investors.
Index funds and the Pareto Principle
Here are two additional reasons why a Coffee Can approach works so well:
- Index Funds and Active Management: Research has shown that index funds almost always outperform actively managed funds over the long run. This is due to indexing’s lower costs, greater diversification, and the difficulty in consistently outsmarting the market. The Coffee Can portfolio mimics this passive approach, leading to potential out-performance.
- Pareto Principle (80/20 Rule): The Pareto Principle suggests that 80% of effects come from 20% of causes. Applied to the stock market, a minority of stocks will generate most of the market’s returns over time. The Coffee Can approach, by holding onto stocks for the long term, ensures that investors don’t cut their winners off.
Warren Buffet’s Approach
The same “buy-and-hold” strategy is also used by other successful investors. The legendary investor Warren Buffett is known for his long-term investment philosophy. He buys profitable companies and then holds onto them, letting compounding work its magic. This approach not only capitalizes on the gains of top-performing assets but also reduces the biases that can creep in when we try to time the market or react to short-term volatility.
The Myth of Regular Re-balancing
Many in the investment industry champion frequent rebalancing. Why? Because it’s an avenue for them to charge fees. However, rebalancing will inhibit your portfolio’s growth potential.
Imagine you have two investments: A and B. If A grows at 7% and B at 4%, frequently trimming A’s gains to balance the portfolio with B will reduce your overall return significantly over the years. Better to simply use new money, and the income received from current investments to re-balance.
Typical Rebalancing Strategy
The traditional rebalancing tactic boils down to: sell the winners and buy the losers. Not only will this hamper performance, but it can also have negative tax implications, leading to capital gains taxes. And, each time a sell is made, we give an opportunity for our investing biases to creep into our decision making.
A Simpler Rebalancing Approach
So, what is the solution? And, how can the average investor successfully employ a buy-and-hold investment strategy that will beat the market over the long-term? Instead of selling high-performing assets, consider using the income generated by current investments and the new contributions made to an account to buy under-allocated investments instead. This way:
- You allow winners to continue their trajectory.
- You can potentially benefit from the eventual rise of underperformers.
- It’s tax-efficient.
A Simple Formula: For a portfolio split 50/50 between stocks and bonds, if stocks surge, instead of selling them, use the dividends and bond interest to buy more bonds instead. Over time, this will naturally rebalance your portfolio without “cutting the flowers”. Or, when your portfolio has 30 stocks and receives dividends and new regular contributions from you. Then, consider using new money to buy the smallest or most promising investments each period (weekly, monthly, quarterly, etc) instead of selling what you already have.
Our Buy-and-Hold Approach
In a world inundated with convoluted financial jargon and ever-changing market predictions, returning to the roots of successful investing often provides the most clarity. The timeless buy-and-hold simplicity demonstrates its efficacy not just in its results, but in the peace of mind it affords to investors. At Markdale Financial Management, we’ve always championed this approach. We believe in crafting financial strategies that are straightforward, transparent, and effective. And, we are happy to benchmark and report our results. Investing needn’t be complicated to be successful. By embracing the power of buy-and-hold and the elegance of uncomplicated strategies, we stand by our commitment to helping our clients gain financial peace of mind.