Questioning the Buy-and-Hold Strategy

To buy and hold or not to buy and hold (apologies to the Bard)? Unfortunately, that's not really the right question to be asking.

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Questioning the Buy-and-Hold Strategy

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Some investors scorched by the tech sector's ongoing free fall are no doubt questioning the buy-and-hold strategy that left them hanging on to growth and tech funds that have been folding for more than a year. But in most cases, the culprit is what was bought, not how. The concept of buying fund shares and hanging on to them for years has merit, but only if you're planning to buy and hold a well-diversified portfolio. A portfolio dominated by the tech-heavy growth funds investors bought in record droves during the past few years -- the equivalent of taking a home-run swing -- doesn't typically fit that bill.

Let's look at how the buy-and-hold strategy should work, how it can backfire and a couple of portfolios that might suit it.

At face value, the buy-and-hold idea is simple, but that can be a double-edged sword.

"People oversimplify the buy-and-hold idea," says Bryan Olson, a director at Charles Schwab's Center for Investment Research. "In reality, it's research and buy what's appropriate and then monitor it. It's not buy it and hold it forever. Your situation changes and the market changes."

Long story short, if you want to buy a few funds and stick with them through the market's gyrations, that's a lot easier to do if they spread your money broadly across the market, reducing your portfolio's dependence on individual sectors or companies. But if you buy five big-cap growth funds -- a common mistake made by countless investors thinking five funds equal diversification -- your peaks would be higher, but likewise the valleys would be lower.

In a way, buy-and-hold investing is like marriage while trading is like dating: With the former you're looking for a bit more stability.

For example, it would have been easier to weather a rough market if you'd bought and held the (VFINX)Vanguard 500 Index fund, which tracks the S&P 500 Index, than if you'd bought and held the average big-cap growth fund. Over the past year, the index fund is down 13.1%, which is tough enough, but the average large-cap growth fund is off more than 30%, according to Morningstar.

And things could be much tougher than that. Consider that the (FDGRX)Fidelity Growth Company Fund, last year's top-selling fund, is down almost 42% over the past 12 months.

The Case for Diversification An index fund like the Vanguard 500 Index has cushioned the blow of the last year without sacrificing returns over the long term

Source: Morningstar. Returns through March 15.

It's easy to understand how buy-and-hold investors went for riskier funds given how little downside they experienced over the past few years. The S&P 500 rang up annual returns of at least 20% from 1995 through 1999, the first time it ever topped 20% for five years in a row. There seemed to be little risk to focusing on leading sectors, given the dearth of extended downturns, and fund companies fanned the flames by rolling out a stunning stream of tech funds while still preaching the virtues of hanging on (the average tech fund is down more than 60% over the last year).

"I think the last year really bears out diversification," says Olson. "Everything we talked about in recent years was tech and telecom. If you'd spread your money across many sectors, you wouldn't be hurting so badly, but if you bought a few big-cap tech stocks or hot big-cap growth funds, you're hurting."

If a more diversified and less volatile portfolio is easier to hang on to, then that's a good thing because it can be costly for long-term investors to be out of the market. Trading in and out of the market can cost you a lot of money because stocks tend to perform in sudden bursts. And missing those bursts can mean much lower returns.

Olson points out that an investment in the S&P 500 would've averaged a 14.8% annualized gain in the 1990s. But if you'd missed the 20 best trading days, admittedly an abstract scenario that ignores the benefits of missing the worst trading days, your returns would be cut to 7.1% -- more than a 50% drop.

Missing Out If you'd missed relatively few of the best 1990s trading days, your returns in an S&P 500 fund would've shrunk in a hurry

Source: Charles Schwab Center for Investment Research.

Sticking with a diversified portfolio that typically has a less wide range of returns makes when you invest less important. If you'd invested $2000 annually in the S&P 500 at the index's bottom for the year over the past 20 years, that account would be worth some $301,000, according to Olson. If you'd invested that $2,000 immediately each year, the account still would've still been worth more than $250,000.

No doubt some tech and growth die-hards will scoff at the idea of a marketlike portfolio. But if you're looking for a portfolio that you can buy and hold, we've pulled together a couple of examples for you. Check out the Perfect Portfolio and the Low-Maintenance Portfolio for those who'd like to spend the minimum amount of time and energy worrying about what funds they own.

Both would've given you solid returns with less risk -- and that's the anatomy of a buy-and-hold portfolio.

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