How To Buy & Hold: Add Cash Savings Alongside Your Low-Cost Stock Index Funds
Buy & hold is a well-known, well-documented investment strategy. It works. But be careful. For me to hold up buy & hold as a smart strategy, I recommend a cash complement.
What is the true story of David and Goliath? Photo by Sean Robertson on Unsplash
This post is part of a 4-part series about smart investing for the semi-retired.
Add cash to your buy & hold portfolio (this post)
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I just heard the story of David & Goliath as told by Malcolm Gladwell in his 2013 TED Talk. His talk flips the classic story on its head and proves that Goliath was the underdog. What? In those days, the slingshot was evidently the weapon of choice for the expert marksman. The lumbering giant never stood a chance.
The talk upset me because I thought I understood the story. The lesson? Never stop confirming what you know and believe. Seek out differing and dissenting perspectives to continue to test your opinions.
Until 2020, I held buy & hold investing in the highest regard. It worked well for me for over 25 years. But the COVID stock market crash that spring scared me. It forced me to reexamine what I thought about buy & hold.
In this post, I break down the pros and cons of buy & hold passive stock index investing. Then, I discuss how and when you should use it and what makes a great complement.
So I won't bury the lead(!), it’s cash savings. Long-term, buy & hold, passive stock indexing works best with a side of safe, easy-to-access cash savings.
What is Buy & Hold?
Buy & hold is a passive investment strategy that tracks a stock market index over the long term. You don’t trade stocks or exchange-traded funds (ETFs) based on market timing. Instead, investors buy and hold them regardless of changes in the stock market.
The buy & hold strategy is popular with financial independence/retire early (FI/RE) advocates. (These are my people.)
Pros of Buy & Hold
I see four key benefits of buy & hold investing.
Buy & hold’s appeal is simplicity. Buy & hold is a mechanical strategy. Investors can tune out pundits offering advice based on market news, which is largely noise.
Passive indexing ETFs have very low costs, especially at Vanguard. With little buying and selling, buy & holders get favorable tax treatment. These low costs increase returns. Reduced costs guarantee higher returns.
Buy & hold stock ETFs outperform other investments like bonds, real estate, and cash savings in the long term. Since 1900, investors have reaped 8–10% returns annually (based on exactly how returns are measured).
Buy & hold investing comes with immense social proof. The greatest investors of all time recommend it. Top buy & holders include Warren Buffett, Jack Bogle, and Peter Lynch. Visible leaders in the FI/RE community advocate for it in podcasts and blogs.
Cons of Buy & Hold
No investment strategy is perfect. I see four major downsides to buy & hold.
Buy & hold is inherently focused on stocks and bonds. Stocks are high-performing investments, and bonds complement stocks nicely. But this is not guaranteed. Just look to 2022 as proof.
Buy & hold investing implies that prices don’t matter. Does buy & hold’s investment style change when stocks are at very high valuations? No. Does buy & hold respect the concept of mean reversion? No. (Mean reversion means that an investment’s price tends to converge to a long-run average price over time.)
Long-term returns are just that. Ten-year periods of negative investment returns for stocks are common. Long-term losses can devastate retirement plans. You need only ask anyone starting retirement in 2000 or 2008. Buy & hold also has a large opportunity cost: investments are tied up for the long haul.
Buy & hold ignores defensive approaches for managing risk. Buy & hold is vulnerable to market risk. Unfortunately, investment losses are asymmetric and compound exponentially.
When to Use Buy & Hold
Use buy & hold strategically and as part of a comprehensive investment approach.
Consider it in two cases.
Stock market valuations are low
Valuation should be enough to warrant strong future investment returns. Buy & hold investing works, but it depends on when you start your investing journey.
Here is a graph of forward-looking 10-year real investment returns at given CAPE levels.
The cyclically adjusted price-to-earnings ratio (CAPE) is a valuation measure. It is the market price divided by the average of ten years of earnings (moving average), adjusted for inflation.
Your investment time horizon is adequately long
Buy & hold investing over 10–20 years will nearly always produce a positive return. But, if you need the money in fewer than ten years, buy & hold alone is not the right strategy for stock investments. When nearing financial freedom, keep money for your immediate needs in cash savings.
Cash Savings Complement Buy & Hold
Cash acts as a margin of safety. A ready, available emergency fund has incalculable returns. It’s responsible and reasonable and enables you to stay the course in other, more volatile yet very sound investment strategies. Best of all, cash savings help me sleep at night. And sound sleep makes for enjoyable living.
Cash savings help you be defensive and go on the offensive.
Cash is defensive.
Cash serves as a volatility buffer when live on your savings. Holding extra cash reduces the chance you must withdraw from your investment accounts when they are down.
Cash is opportunistic.
You can be greedy when others are fearful. Having cash after markets drop lets you buy wonderful investments on the cheap! Selecting high-performing investments during market downturns is smart.
How much cash should I keep?
My advice is for those of you nearing or living with financial freedom. I recommend holding cash in an amount that is the greater of a) three years of living expenses or b) 20% of your investment portfolio.
Of course, this is an approximation and will change based on what’s going on in your life. For example:
Your cash will drop upon pursuing an opportunity where you have an edge. This could be an investment in your micro-consultancy or other higher-yielding market investment.
You can also get away with holding less if you have access to cash through a 401(k), cash-value life insurance policy, or other asset.
For more information on the best places to store cash, check out my post (from a former life). Do your research among the three: high-yield savings, U.S. treasuries, and money market accounts backed by the U.S. government.
Remember that buy & hold passive stock index investing has benefits and drawbacks. Watch CAPE levels and remember your investing time horizon. Also, keep some money safe in cash savings.
And keep investigating buy & hold. There is always more to learn. Maybe you’ll find even more nuance in the story of buy & hold…just like in the story of David & Goliath.
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Brian Herriot buys & holds (now alongside cash savings) from his home in Alameda, California, and cabin in Hazelhurst, Wisconsin. He also prepares financial freedom plans for consultants and other mid-career professionals in one-week sprints. Check out his take on a new and different kind of retirement at choosyconsultant.com.