Think investor. The other side of buy- and-hold strategy

An article on the Internet shows that buy-and-hold index strategy outperformed active buying and selling stocks over several 10-year holding periods.

This could be arithmetically true. A buy-and-hold strategy could be useful when you do not have a defined investment horizon but could be harmful for goal-based investments.

In this article, we show why this could be the case.

Terminal wealth

Terminal wealth refers to the amount in your portfolio at the end of the time horizon for a life goal; terminal wealth must be equal to the required amount to achieve a goal.

A goal-based portfolio typically has investments in equity and bonds. Your bond investments can be in stable-income products such as bank fixed deposits. Importantly, the actual return will be equal to the expected return, ignoring the bank’s default risk. Your equity investments are exposed to market risk. This means the risk of a goal-based portfolio earning lower than required return will be entirely because of equity investments. So, managing the risk associated with your equity investments is important.

Suppose you invested ₹5 lakh last year and the investment accumulates to ₹5.6 lakh this year for a 12% gain.

Ignoring your contributions to the portfolio this year, what if the market declines by 10.7%?

The entire gains in your portfolio will be wiped out! This leads to a larger issue. Suppose the time horizon for your goal is 10 years and the required return on equity is 12%, your equity investment must earn 12% on a compounded basis to achieve the terminal wealth.

Any shortfall in return will be compounded over the time horizon for a life goal leading to goal failure. You must, therefore, manage your equity investments through a re-balancing process.

Conclusion

Re-balancing process refers to the adjustment of your equity allocation to manage risk. It is important to keep the process simple.

You could take profits on your equity investments when returns are greater than 1% in any year and invest the amount in fixed deposits. That way, you can capture the excess returns over the required return to achieve a goal.

Also, you must contribute more capital to your equity investments in any year when there is shortfall in returns. This money can come from your salary increase and from the deposits created from the excess returns. The upshot? Buy-and-hold strategy may not work for goal-based investments. Managing risk is important.

(The author offers training programmes for individuals to manage their personal investments)