This week's wild stock market swings help to make the case for the "buy and hold" investment strategy. Buy and hold investors in the U.S. stock market made an average annual return of 8% during the 15 years from 1995 through 2009.
When Burton G. Malkiel first published "A Random Walk Down Wall Street" almost four decades ago, he argued that market swings were essentially impossible to predict. Malkiel concluded that short-term market moves were random and that the only way to make money was to take advantage of the market’s long-term trend toward the upside.
Foreshadowing the now booming index mutual fund business, he described an investment vehicle that would allow the small investor to “buy the averages,” since, as he pointed out, so few actively managed funds managed to beat them.
In addition to defending out-of-favor investment techniques such as “buy and hold” and diversification, Malkiel restated his position on index funds in a recent Wall Street Journal op-ed piece adapted from the 10th edition of his landmark book. According to Malkiel, only about one-third of actively managed funds outperform low-cost index funds and the list of those that do changes often, making it hard to pick a fund manager who will be a winner.
Index funds, on the other hand, have the advantage of low costs. The returns of winning fund managers are impacted by higher expense ratios, which can be several times more than a low-cost index fund. With the help of some online research, an investor can easily find an index fund with an expense ratio below 0.2%, compared to an average expense ratio of 1.5% for an actively managed stock fund.
Malkiel also argues that the “buy and hold” investment strategy isn’t dead. He points out that investors who bought stocks back in 1995 and held on through both the bursting of dot.com bubble, as well as the market meltdown of 2008-2009, had an average annual return of 8% through 2009. If they missed the 30 best days over that period by trying to time the market, however, their results would have been in the red.
By sticking with dollar cost averaging -- putting a set amount of cash into the market at regular intervals -- investors can even out market swings. You may pay a premium at times, but you are also assured of buying at market lows.