Buy and Hold Can Pay Off

by Alan Lavine and Gail Liberman

In many of the recent mutual fund scandals, all the talk has been about profits made by deals mutual fund families cut with market timers.

It sure seems like the market timers knew how to rake in the big bucks!

But new research reinforces an old school of thought. Market timing doesn’t pay in most cases. 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 the reinvestment of dividend income.

When you buy and hold for at least one year, you also 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, which can be as high as 35 percent.

A 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, based on historical returns.

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 the buy-and-hold investor made $1,104 more because he or she did not pay short-term capital gains taxes on the profits. The investor who bought and held the stock fund would have $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.

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 investment. You also might want to sell your mutual 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 historically have 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 should be less than the market price when you sell.

Alan Lavine and Gail Liberman are husband-wife personal finance columnists, journalists and authors. They are the authors of "Rags To Retirement," published by Alpha Books. Their columns appear in newspapers throughout New England and the Southeast, as well as online. Their commentary on mutual funds and personal finance is carried by 200 radio stations nationwide every Sunday over Business News Network's Charles DeRose Financial Advisor Show. Al and Gail’s new book is "Rags To Retirement:  Stories from people who retired well on much less than you think," published by Alpha Books.

More articles by Al and Gail can be found here.