Dynamic Strategies: Buy Hold

Posted By: Advisor Analyzer Team

As the old saying goes, there is more than one way to skin a cat. Similarly, there is more than one way to invest and maintain one’s investment portfolio. Anyone involved in the markets know that investment management is not a onetime event, but a dynamic process. An investor may buy and subsequently sell an investment when it does not perform as expected. Some may rebalance to maintain their initial allocation, and others may exercise a buy hold strategy. While it is difficult to determine which is best, we are able to distinguish the pro's and con's of each strategy.

Buy-and-Hold Strategy

The buy-and-hold strategy maintains a linear exposure to the value of equities. Simply put, the strategy creates a portfolio that will go up and down with the market investment’s movements. The strategy involves buying, then holding, an initial mix of investments such as equities and fixed income securities. Regardless of what happens to the underlying investment values, no rebalancing required; hence this is often termed the “do nothing” strategy.

Payoffs:

The payoff for a buy-and-hold strategy is a linear (straight line). Therefore, the value of the portfolio rises (falls) as equities rise (fall). The slope of the buy hold strategy payoff line will be equal to the equity proportion in the initial mix. Therefore, if 50% of your assets were in equities and equities depreciate 10%, your portfolio will fall by a proportionate amount (5% = 50% X 10%). The portfolio value never falls below the specified minimum (floor) while maintaining unlimited upside potential.

Performs Best/Worst When:

Given the unlimited upside potential, the buy hold strategy performs best when equity prices are increasing. The strategy will perform well when there is a greater equity allocation in the initial investment mix. Conversely, the strategy performs poorly when equity prices are declining, and the greater the proportion of equity exposure in the portfolio, the worse the portfolio performance.

Ideal Investor for Strategy:

The strategy is particular appropriate for an investor with below average risk tolerance for the portfolio’s returns below a specified maximum loss amount (floor). However, the investor should be more open to volatility (risk) above the loss level. Basically, the investor doesn’t mind price fluctuations above the minimum, but refuses to have the portfolio fall below the specified level. Therefore, risk tolerance above the specified floor varies with wealth, but drops to zero at or below that floor.

Cost of Implementing Strategy:

Aside from any initial portfolio transactions, transaction costs are very minimal, since the investor will only sell at the floor level, or whenever they would like to permanently decrease equity exposure. The strategy is tax efficient for taxable investors, since there is usually little short term capital gains tax.

Conclusion

There are many more portfolio strategies available to investors, but the Buy Hold, Constant Mix, Constant Proportion strategies are most often used by financial professionals today. Investors that properly utilize the correct strategy for a given market environment can claim superior portfolio performance over their investing peers who practice a wrong strategy. However, no single strategy can claim absolute superiority to another at all times, since each strategy has its unique merits and shortcomings in skinning the financial cat.