Making buy-and-hold investing work

Go ahead and invest for the long haul, but lock in your profits once your targeted return is achieved

By Vasu Menon


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The success of any investment strategy depends, among other things, on when you make your foray into markets, whether you overpaid for your investment and if you had locked in your profit when your targeted return is met.

THE extreme volatility in global stock markets over the past three years has raised questions about the wisdom of a buy-and-hold investment strategy, epitomised by one of the world's best investors, Warren Buffett.

Mr Buffett's investment philosophy of buying outstanding companies at a fair price and holding them for long periods is often cited as a strategy for successful investing. No doubt, Mr Buffet has done very well with this strategy, and it has made him one of the richest men in the world. But does the strategy still work in this new age of investing, where significant uncertainty and volatility appear to have become fixtures in the marketplace?

A look at the Chicago Board of Options Exchange's VIX index shows that market volatility has increased significantly over the past three years after the onset of the US sub-prime crisis in 2007.

The US sub-prime crisis and the debt woes in Europe have highlighted deep-seated problems in Western economies and financial systems, which could take several years to resolve. The dislocation and uncertainties posed by these problems are likely to resurface regularly in the coming years, causing intermittent turbulence in financial markets and sharp pullbacks.

Given this prognosis, does it make sense for investors to take a strategic or long-term view of their investments or should they be trading markets instead, to get the most out of their money?

While more turbulence and market volatility seem a surety, the question that investors have to ask is whether markets are likely to trend higher over the next few years or if the uptrend will stall and give way to a bear market.

No one can predict this with certainty; but if investors are comfortable that economies are on a gradual mend and earnings of companies will continue to recover, then fundamentals should eventually prevail. This, coupled with still attractive medium-term valuations, should help markets head higher, even though the road ahead will be a bumpy one.

Despite the uncertainties looming on the horizon, there is a role for both strategic and tactical investments in one's portfolio. It is important for investors to be very clear about their objectives from the onset, and be disciplined and unemotional about their investments.

It is perfectly alright to trade in markets, but limit it to a small portion of your portfolio and set realistic targets. If you are aiming for, say, a 30 per cent return in a short span of time, this may be unrealistic. However, a 5 per cent target may be something that is more realistic and achievable in the short term. Also with tactical investments, be sure to set loss limits to minimise losses.

However, the bulk of one's investments should still be invested with a strategic view of at least three to five years.

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For strategic investments, even though you may start off investing with a view of say five years, it does not mean that you have to stay invested for the full period. This is where many investors get it wrong with the buy-and-hold strategy.

A cardinal mistake that many investors make is to set off investing for the long haul, with a certain return in mind, but they do not take profit when their target is achieved because they get overcome by greed and hold on to their investment, hoping to make even more gains.

If your investment objective is to make a return of say 8 per cent per annum over a five-year period, it works out to a targeted total return of 40 per cent. Now if for some reason, you make that return in say one year or two years instead of five years due to a sharp rally in the markets, like we saw for many bourses in the past 12 months, then it is probably best to sell and lock in your profits when you have hit your target, even if it is well before your five-year time horizon.

The fact of the matter is that, unless you take profit, you will never realise your gains, which could wither away if markets experience a downturn subsequently.

Let's take Singapore's benchmark Straits Times Index (STI), for example. It was trading at around the 800 level in September 1998 and currently stands at around 2,800, representing a significant 250 per cent total return in almost 12 years.

However, an investor who had ploughed his money into the STI in September 1998 could have done even better if he had locked in profits just 15 months later as the index had surged more than three-fold to about 2,600 in January 2000, at the height of the technology fervour.

The gains would have been much smaller if the investor had held on to his investment and cashed out after four to five years, as the STI fell significantly after the technology bubble burst in early 2000.

On the other hand, if an investor was swayed by the market frenzy during the Internet boom in January 2000 and made his foray into the STI then, he could be sitting on only a small gain despite buying-and-holding for more than 10 years, as the index is currently trading just 200 points above the 2,600 level.

The chances of success are likely to be lower if you indulge in indiscriminate investing, buying the flavour of the month at any price, and holding it no matter what. In essence, the success of any investment strategy depends, among other things, on when you make your foray into markets, whether you overpaid for your investment and if you had locked in your profit when your targeted return is met.

A buy-and-hold strategy is premised on the assumption that you stand to enjoy better returns if you invest for the long haul. Time increases the probability of achieving better returns, but it is not a guarantee. So go ahead and invest for the long haul, but hedge your bets by locking in your profits once your desired return is achieved. In other words, buy-and-hold until your investment meets your targeted return. Once your target is met, be disciplined about selling and locking in your profit.

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There should always be an exit strategy for whichever investment strategy you subscribe to, and buy-and-hold is no exception. If the original premise for your investment changes and the fundamentals take a significant turn for the worse, it may be better to liquidate your holdings before your investment horizon runs its full course, even if it means suffering losses.