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Buy and hold may not be cool, but it’s very effective

What do fund managers tell us to do? What do fund managers tell us to do?

Buy and hold, ride out the bumps, stay invested for the long term.

But behind the façade, do they practice what they preach?

NO –  they buy-sell-buy-sell-buy-sell in a frantic and desperate bid to top the performance tables for the next quarter.

That’s why they under-perform the average stock market growth.

Three problems with high-frequency trading

1)      Transaction costs – these tend to be lower in shares (brokerage costs, stamp duty – though no stamp in Oz thankfully) than they do in property (stamp duty, legal fees, agent’s fees), but they are still there and they do have an impact

2)      Poor timing – most people are rubbish at timing the top and bottom of the market

3)      Capital gains tax

Effect of tax

Here’s a hypothetical investment that doubles in value each year and then tax is paid at a notional 30% on the profits before reinvestment:

Starting capital

Capital doubled to:
Tax at 30%
Finishing capital
$10,000
$20,000
$(3,000)
$17,000
$17,000
$34,000
$(5,100)
$28,900
$28,900
$57,800
$(8,670)
$49,130
$49,130
$98,260
$(14,739)
$83,521
$83,521
$167,042
$(25,056)
$141,986

Here’s another hypothetical investment where the investor holds for the full 5 years then sells, incurring capital gains tax at the reduced rate of 15% (see note below):

Starting capital
Capital doubled to:
Tax at 15%
Finishing capital
$10,000
$20,000
$-
$20,000
$20,000
$40,000
$-
$40,000
$40,000
$80,000
$-
$80,000
$80,000
$160,000
$-
$160,000
$160,000
$320,000
$(43,500)
$276,500

In Australia there is a 50% exemption where an asset is held for more than 12 months.

Complicated, but the principal here is the important thing!

Table 2 shows that while the tax is Year 5 is rather eye-popping, the net result is far better.

Do the rich pay much tax?

Well, we know that companies sure don’t – but what about individuals? 

We know that Kerry Packer wasn’t a fan of tax telling the Senate that people who didn’t minimise their tax “need their heads read” because governments tend to waste a lot of taxpayer money.

George Soros took a different approach, incorporating his famous Quantum Fund in a tax haven (Netherlands Antilles).

Warren Buffett minimises his tax in two ways.

Firstly his company Berkshire Hathaway has only ever paid one dividend (dividends from company profits are effectively taxed twice, once in the company and once in the hands of the recipient).

He mused: “I must have been in the bathroom at the time.”

The second way he reduces the impact of tax is by not selling.

Buffett’s preferred timescale for holding a quality investment is forever

What does it mean for us?

The buy and hold strategy offers the average investor the best chance they have of not being average.Hold it for the long term

The strategy that is most often effective is:

  • Identify a quality asset (shares in a great company or property in a great location)
  • Buy it at the right price (also known as investing counter-cyclically or “don’t follow the crowd”
  • Hold it for the long term

It’s a long way removed from the Gordon Gekko image of the mad-crazy-impulsive Wall Street trader.

But guess what?

It also works.



Want more of this type of information?


Pete Wargent

About

Pete Wargent is a Chartered Accountant, Chartered Secretary and has a Financial Planning Diploma. He’s achieved financial freedom at the age of 33 - as detailed in his book ‘Get a Financial Grip – A Simple Plan for Financial Freedom’. Pete now manages his investment portfolio, travels and works as a consultant in the finance industry from time to time. Visit his blog


'Buy and hold may not be cool, but it’s very effective' have 6 comments

  1. May 30, 2013 @ 8:48 am Minh Nguyen

    I agree that property investment is a long-term strategy because of its associated high costs. It appears that the author does not know much about how to make money in the share market. Buy and hold strategy in the stock market is lazy investing and will never work particularly in this volatile investing environment. This strategy only works in a bull market. Then again, everyone including your dog would be able to make money in a bull market. The important isssue is to decide when to get out of a bull market and protect your profit before the arrival of a bear maket. Just to illustrate the point, people who bought Rio Tinto shares at the height of a bull market in 2007-2008 just before the GFC at around $150 per share (its share price is around $54 now) will need to wait a long long time before the share price goes back up to $150, if this ever happens. To be sucessful in the stockmarket, people should be vigilant, “keep your eye all the ball” and have a plan to protect the profit (that is they will need to sell if required) and have a plan to get back in. It is impposible to time the market but is is possible to time the individual stocks but that will need a bit of work. A good strategy is to make money in the stock market and then invest in properties long-term because of its less volatile nature. By the way, it is misleading to say that “dividends from a company profits are taxed twice”. This depends on your tax rate and if you are on a low tax rate or invest in super fund environment, you will get more money (on top of the dividends) from the Tax Office due to franking credit.

    Reply

  2. Pete Wargent

    May 30, 2013 @ 10:48 am Pete Wargent

    Hi Minh,

    Thanks for the comment. You may think it’s lazy, but I can tell you it’s extremely effective when done properly through a regular buying strategy, because shares are an income asset as well as a growth asset. I’ve been hitting up the FTSE for 17 years now and it’s done very well over that time, delivering great income growth and capital appreciation.

    That’s not to say I don’t suggest timing the market to some extent. I’d very much recommend buying as hard as possible when the market is depressed – we’ve had two major corrections since 1996, and on the XJO I certainly enjoyed picking up Wesfarmers at $15 (others would say the same about CBA etc.) and the dividends it throws off today are nothing short of fantastic (and it trades above $40).

    For sure there’s more than one way to skin a cat as I covered in some detail in my book, but in my experience well over 95% of people are completely hopeless at executing accurate market timing. No doubt you’ll tell me you’re great…and that’s good!

    As for whether dividends are taxed twice – maybe not for everyone due to franking credits, but unfortunately some of us are top bracket taxpayers, so they can be partly taxable.

    That said, Keating’s introduction of the dividend imputation was a marvellous improvement on the previously iniquitous tax law, and very helpful (though personally I reinvest dividends via DRP to avoid paying unnecessary tax on them).

    If anyone really wants to outperform using the buy and hold method by finding the outperforming sectors and efficient investments, read ‘Motivated Money’ by Peter Thornhill. Peter is a truly great guy and educator and is living proof that – if you know what you are doing – buy and hold can turn salaried employees into multi-millionaires – in equities as well as real estate.

    Cheers,
    Pete

    Reply

  3. May 30, 2013 @ 12:47 pm Minh Nguyen

    Hi Pete
    If you are investing in the index long term as also advocated by Peter Thornhill you are making a very big and risky assumption that the stock maket will always go up in the long run. Try tell that to the Japanese people. Between 1989 and 2008 the Japanese stock market fell around 80%. That’s an annual average negative compound negative return of minus 8.7%, for 19 consecutive years. If you ever want some objectivity about the stock market going up in the long run just ask someone from Japan. Australian long term equity optimism is based on the past, the uptrend may or may not happen in the future. To minimise this risk we will need to be able to select stocks, know the stocks well; and try to make money by timing it (just in case we need to use this strategy in the future). This is what I call active investing. The risk with people using buy and hold strategy is that they would become paralised and not knowing what to do when the bear comes knocking on your door.

    Regards

    Minh

    Reply

  4. Pete Wargent

    May 30, 2013 @ 1:20 pm Pete Wargent

    Hi Minh,

    I don’t see any parallels at all between Australia and Japan, sorry.

    I don’t believe we will ever see Australia’s population falling in my lifetime and nor do I believe we will see a long period of deflation without intervention given our Central Bank policy of targeted inflation.

    I would, however, like to see another correction at some point so I can buy more when the market is low and continue to benefit from the dividend streams which have been growing in Australia’s most profitable companies for decade after decade after decade.

    Good luck with your strategy.

    Pete

    Reply

  5. May 30, 2013 @ 2:53 pm Jonathan Fenn

    The lucky country we live in!

    Reply

  6. November 7, 2013 @ 5:07 pm Varad

    Very nice and informative article Pete.

    Reply


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