A lot of people have got rich by investing in shares and simply holding on to them for a long period of time. Buy and hold is a passive strategy, a very easy and comfortable way of investing in shares. But the last couple of years, buy and hold investors have not made any progress. Is buy and hold still the right strategy for investing in shares?
Buy and hold worked very well on the stock markets in the 80s and 90s. As long as shares go up, on average, at least 10% per year, the compound interest will create small fortunes even out of modest amounts. Buy and hold is a very simple strategy and it requires very little ongoing work.
You may already know that compound interest over time works wonders. But this requires that the annual growth is reasonably high. It must be at least a few percent higher than the inflation, otherwise you are not building any real wealth.
What becomes of $2400 invested each year, at different growth rates
As can be seen in the table above, over time even small amounts become huge over time. But you need a reasonable annual growth rate, otherwise it will take far too long. At 4%, your money does not grow much. It gets better at 6% but you still have to wait at least 30 years before the compound interest really starts to work. You really want at least 8% annual growth in order to start enjoying the magic of compound interest. But look at the difference between 8% and 10%, after about 25 years the difference of only 2% in annual growth starts to explode. At 12% growth, your money doubles every six years. As can be seen in the table, at this growth rate, even small amounts become huge within a reasonable timeframe. Of course, at 14% the magic of compound interest kicks in early. But it is far from easy to achieve 14% over 20 years or more.
Cheap index funds are the best solution for most people who want to invest using the buy and hold strategy. It has turned out that very few active managed mutual funds manage to beat cheap index funds over longer periods of time. When looking at performance over ten years or longer, cheap index funds are only beaten by about ten percent of the actively managed funds. And extremely few mutual funds manage to beat index funds with any significant amount. Also note that in reality index funds are even performing better than the statistics show. The actively managed funds only include the funds that have survived for ten years or more. Funds that have been closed or merged into other funds are not included. In almost every case the funds that have disappeared have been underperformers. Thus, the chance of selecting an actively managed fund which can significantly beat a cheap index fund is extremely small. Just selecting a fund that can match an index fund over longer periods of time is very difficult.
But some people insist on that individual investors can beat index over time. Most mutual funds are simply too large to be able to just select the few shares which they really believe in. A small investor on the other hand can invest in just a few companies. But if you want to beat index, you have to be prepared to take bigger risks and also to sell underperformers, which is not what a buy and hold investor would do.
In the 1980s and 1990s it was relatively easy to find shares that performed better than index for a very long time. Those who bought shares that increased ten or twenty fold got wealthy by just hanging on to their shares. You can still find such shares but it has become much more difficult. Needless to say, holding on to underperforming shares is not the fast way to riches.
So is buy and hold still a viable strategy on the stock markets? It certainly is the easiest strategy for most people. Unfortunately, it may not work as well as earlier, due to the fact that the last couple of years many stock markets have performed poorly. But unless you are prepared to learn about the stock markets and analyze shares, investing in cheap index funds and holding on to the investments is the best option. Despite the relatively poor performance of many stock markets, it is still advisable to have a large portion of your wealth in shares. But it can be worth looking at shares outside Europe. The US stock market may recover but it looks like many European stock markets will underperform for quite some time.