The Math of Buy and Hold
Many financial advisers warn clients that they should not try to time the stock market. Indeed, research indicates that individuals tend to buy when stocks are going up and sell when stocks have gone down: a buy-high and sell-low approach that reduces long-term returns. Consequently, some investment pros support a strategy known as “buy and hold.”
Example 1: Julia Martin consults with a financial planner and agrees to an asset allocation of 60% in stocks and 40% in bonds. Although Julia may periodically change the stocks and stock funds she owns, for specific reasons, she maintains this 60-40 asset allocation for many years. Not until she approaches retirement and desires a more conservative portfolio does Julia trim her stock position to 40% of her holdings.
Patience can be prudent
Assuming that Julia holds well-chosen stocks and funds, this strategy probably will provide Julia with the market’s long-term returns, which historically have been excellent. According to Morningstar’s Ibbotson subsidiary, through 2014, large-company U.S. stocks have had annualized returns around 8% for the past 10 years, 10% for the past 20 years, 11% for the past 30 years, and 12% for the past 40 years. (Those returns assume dividend reinvestment, no taxes, and no transaction costs.)
Going back nearly 90 years, to the beginning of the Ibbotson data base, U.S. stocks have annualized returns of about 10%. Generally, the numbers for stocks are significantly higher than the returns for bonds or cash equivalents. That’s no guarantee of future success, but it’s telling that U.S. stocks have been good long-term investments through recessions, depression, wars, turmoil, booms, and busts.
Putting those numbers in perspective, assume that investors in the future net 7.2% a year from stocks, long term. At that rate, money doubles in about 10 years. If that’s the case, a $10,000 investment today would grow to $20,000 by 2025, $40,000 by 2035, $80,000 by 2045. Thus, buy-and-hold investors can expect to enjoy portfolio growth if they can stomach the price volatility along the way.
However, dealing with stock price volatility is not just an emotional matter. There are dollars-and-cents implications as well. In the two bear markets of this century (2000–2002 and 2008–2009), the broad U.S. stock market dropped by about 50% of its value each time.
Example 2: Assume that Julia had $400,000 of U.S. stocks in mid-2008, with a portfolio basically aligned with major indexes. By early 2009, her stocks were worth only $200,000. After that 50% drop in value, Julia needed a $200,000 gain—100% of her early 2009 portfolio—just to get back to the $400,000 she had in mid-2008. Indeed, it wasn’t until 2013 that stocks recovered all of their losses.
Such a steep loss and prolonged recovery period can be disheartening. The damage might be especially severe if it occurs just before you need the cash to fund a home purchase or a college education, for example. Retirees who are drawing down their portfolios, without earned income to invest at lower stock prices, may run short of money after an ill-timed bear market.
Wary investors may want to move out of stocks after years of positive returns. Such a tactic will lock in profits and reduce exposure to a market correction. However, selling stocks at a profit can trigger capital gains tax. The basic tax rate on long-term capital gains (for assets held more than one year) is 15%, but the rate for high-income investors is 20%. The total payment may be increased by state tax, the 3.8% tax on net investment income, and various other tax code provisions.
Example 3: Assume that Julia now holds $500,000 worth of stocks, which she purchased for $280,000, for a $220,000 gain. Also assume a total tax obligation of 25%, federal and state. Julia would owe $55,000 in tax (25% of $220,000) on a sale of all her stocks, leaving her with a net of $445,000. From that point, Julia would need only a 12% gain to get back what she lost in taxes, when she decides that stocks are once again an attractive asset class.
The Team-Your Broker and Accountant
The individual holdings in your account may have different acquisition dates and cost. One mutual fund or stock could have “lots” with very different costs. By working with your accountant and broker, you can identify which lot will generate the lower gain or larger loss to maximize your tax savings. This identification should happen before the sale. You have a limited time after year end to change the lot for tax reporting.
All investors should have a plan tailored to their specific needs, perhaps one that was created by a financial adviser. In general terms, though, buy-and-hold investing can be an effective strategy for truly long-term purposes.
Timing the stock market may not work, but reducing stock positions after a long upward surge might result in less exposure to a coming pullback. Even at today’s higher tax rates, taking stock market gains can be less expensive than suffering a sharp bear market setback. Indeed, trimming appreciated stock positions in tax-favored accounts such as IRAs will eliminate immediate tax obligations.