One of the many common debates in the mutual fund industry pits the advocates of a buy and hold strategy versus those who think that greater returns can be had if they are able to time the markets effectively. Of course, there is substantial historical evidence to support both arguments, depending upon how the data is interpreted.
The right choice for each investor will depend on several factors, including risk tolerance, time horizon and knowledge and experience.
As their names state, market timing and buy and hold strategies are simply two different methods of purchasing and holding mutual fund shares. Market timing strategies attempt to profit by buying mutual fund shares when prices are low and selling them when they are high on some sort of consistent or periodic basis. A buy and hold strategy obviously requires the investor to simply buy shares and then hold them for an extended period of time, regardless of how the markets perform.
Which is Better?
As mentioned previously, there are numerous arguments and statistics that can be used to back either one of these trading strategies. However, neither of them can be considered better than the other in any absolute sense; it will always depend upon the specific fund and investor in question and the circumstances that are involved.
Buy and hold strategies are often recommended for long-term investors who have time to ride out the ups and downs in the markets over a period of years. They are also typically appropriate for novice or uneducated investors who do not understand the markets but still need long-term growth or income. This is, of course, the simpler of the two types of strategies, which is one of its chief advantages. Investors who follow this strategy can put their money on automatic pilot and forget about it, so to speak. And this strategy usually does work over longer time frames, such as ten years or more, particularly in the equity sector. But it becomes less reliable over shorter time frames, such as one to five years if the investor’s principal is at risk.
See our Beginner’s Guide to Asset Allocation.
Market timing strategies, on the other hand, may work in any time frame-as long as the market is timed correctly. This, of course, does not always happen, and no timing strategy has ever shown itself to be foolproof. In fact, one analytical study of the market has shown that it takes virtually perfect timing in order to beat the other strategy.
What is the Statistical Evidence?
A look at performance of the Standard & Poor’s 500 Index from 1993 to 2012 reveals some interesting results when you take five different approaches to buying into it. If you were to invest $2,000 annually for each of the strategies, then you will end up with $87,004 at the end of 20 years if you bought at every low and sold at every high with perfect timing. But the buy and hold strategy comes in a close second with a final total of $81,650, which is even ahead of the stalwart dollar-cost averaging strategy, which netted $79,510 by the end of 2012. And, of course, a market timing strategy where you bought and sold at the worst possible times would leave you with $72,487, while putting the money in cash would net a mere $51,281.
This illustration shows that while it is theoretically possible to beat the buy and hold strategy over time, it is for all practical purposes impossible to accomplish in a real sense, since no one would have been able to correctly predict every single high and low in the index (or any other index or market) over a 20-year period. The group that conducted this study repeated this analysis over 68 other 20-year periods dating back to 1926, and the final rankings were identical in all but ten of those periods. And in those periods, the buy and hold strategy still came in second four times, third place for five periods and fourth place one time, from 1961 to 1982. These rankings also remained largely intact for 30, 40 and 50 year periods, with a few exceptions.
Nevertheless, despite the clear advantages that buy and hold strategies offer, there will always be those who seek to achieve higher returns by moving into and out of the markets according to a specific strategy. And there are times, at least in the short run, when this can be a good idea. Many of those who got out of the market in 2007 and bought back in during the spring of 2008 enjoyed substantial short-term gains, especially if they invested in stocks of financial companies like Bank of America and AIG.
The overall markets do also move in somewhat predictable cycles in conjunction with the economy, and there are usually fairly clear signals that can be seen by analysts when its current trend is about to change. But the ability to predict these trend reversals precisely enough to profit from them in the short run can be virtually impossible in many cases. While longer-term movements can be anticipated with reasonable accuracy, short-term swings often come out of nowhere and can drastically impact the returns posted by market timers.
The Bottom Line
Although it may seem a bit boring, investors who buy and hold for the long term usually do better than those who attempt to time the markets on a regular basis. This difference becomes more marked over longer periods of time, but market timing may still be a viable option for those who are able to closely monitor the markets and trade according to a plan, without letting their emotions control them.
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