Buy And Hold Investing Can Pay Off
- Alan Lavine and Gail Liberman
There's been a lot of talk lately about all the profits that were made by market timing. But new research reinforces the old school of thought. It's still better to buy and hold.Why?
You benefit from the compounding of your investment return. The total return on an investment includes both the dividend or interest income and the price appreciation in a security. Historically, almost 40 percent of the return on the S&P 500, an index of 500 large companies traded on the New York Stock Exchange, is due to reinvestment of dividend income.
When you buy and hold for at least one year, you benefit from the capital gains tax rate, which has dropped from 20 percent to 15 percent. By contrast, short-term capital gains are based on your ordinary income tax bracket. So if you were in the 35 percent tax, bracket, you would pay 35 percent on profits from stocks held less than one year.
A new study by the Vanguard Group, Valley Forge, Pa., compares holding a stock fund for at least five years with selling it every year for five years. Assume that each investor is in the 35 percent tax bracket and invests $10,000, which grows at an 8 percent annual rate. The results show:ye The investor who bought and held the stock fund for five years has $13,989 after five years.
The investor who bought and sold the stock fund every 364 days for five years, generating short-term capital gains, had just $12,885.The buy-and-hold investor made $1,104 more because he or she did not pay short-term capital gains taxes on the profits.
Of course, not everyone can buy and hold. Nor, unfortunately, are we all in the 35 percent tax bracket. If your financial condition changes, you may need to sell your fund. You also might want to sell your fund if it gets a new manager or if it performs poorly.
Buy-and-hold investing, however, continues to work best under these conditions:
- You invest in a low-cost index fund that tracks the overall stock market. Index funds have historically outperformed 60 percent of all actively managed stock funds over the long term. That's because your chances of picking a top-performing fund are slim.
- You use dollar cost averaging to invest for the long term. With dollar cost averaging you invest the same amount regularly. That way you buy shares at lower prices when the market is down. Over the long-term, the average cost of your investment will be less than the market price when you sell.
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Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books).
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