The guide to building an ETF portfolio proposed in the previous sections assumes that you will buy and sell securities with the sole aim of putting in place your optimal asset allocation, without trying to time the market.
This is known as a buy-and-hold strategy, the simplest and most effective to invest in the long run. However, it is not the only one you can pursue. Investment strategies can be divided into 3 groups: buy-and-hold, market-timing, or a combination of the two. Let’s take a look at them.
Buy and hold
As said, this is the simplest and most effective strategy in the long run. You select an asset allocation that maximises your expected return given your chosen level of risk, you buy the necessary securities, and you stick with them for the whole duration of the investment independently on the ups and downs of the markets. You only sell securities when rebalancing and to liquidate your investment at the end.
This passive strategy is built on the assumption (based on historical evidence) that, in the long run, global stock markets tend to go up. The main factors driving this tendency are population growth, which increases the demand for goods and services, and technological innovation, which makes companies more productive. In the long run, the combination of these two forces tends to increase company profits and valuations accordingly.
Therefore, following this assumption, if you hold a diversified stock portfolio long enough you should end up with a profit. This makes buy-and-hold an effective strategy in the long term, even though it doesn’t ensure that it will work on shorter periods of time, over which returns can be significantly affected by volatility.
Also, its results rely heavily on the effect of compound interest: by reinvesting dividends from stocks and interest payments from bonds in the portfolio, you’ll increase your capital periodically, harvesting higher interests and dividends each time, in a virtuous cycle that will make your investment grow exponentially. But compound interest takes time to work, and that’s another reason why buy-and-hold is more effective in the long run.
There are two ways you can implement the buy-and-hold strategy. You either invest a lump sum or you distribute your purchases over time in smaller periodic installments — a method called unit-cost averaging. Both of these approaches have advantages and disadvantages.
If you have a sum at your disposal, you can decide to invest it all together. In theory, this would be the best approach, because it gives your entire capital more time to grow and maximises the compound interest your investment can generate.
On the other hand, imagine doing this at the tip of a market bubble. Seeing your portfolio crash right after you invest and not recover for years may be taxing on an emotional level. That’s why, even if you have a sum to invest all at once, you may decide to dilute your investment over time, sacrificing part of the potential returns for some more peace of mind and liquidity.
Unit-cost averaging works like this: you invest the same amount of money in the same assets on a regular schedule (monthly or quarterly). When the price of the portfolio rises, your fixed sum will buy less of it, but when it falls, it will buy more. This way, you will accumulate more units of it at lower prices and fewer at higher ones, averaging out the cost of your assets.
This method minimises the downside risk of your investment, alleviating your worries when markets go down. In fact, on an emotional level, this is probably the best approach: when prices climb, you’ll be happy to see your portfolio grow, when they drop, you’ll see it as an opportunity to decrease the average cost of your investment. You can implement unit-cost averaging on BUX Zero by setting up recurring bank transfers from your banking app.
As seen, theoretically, buy-and-hold is quite a simple strategy, but it requires a lot of willpower. You’ll have to stick to it no matter what happens on the stock market, which can turn out difficult in times of high uncertainty. When prices climb fast above all-time-highs, you’ll be tempted to sell out of the dread of an imminent collapse. On the contrary, after a crash, you may feel the fear of missing out on a good opportunity to invest more. A unit-cost averaging approach can help you keep your discipline throughout the investment process, but it will do it at a cost over the potential returns of investing a lump sum.
Market timing
Market timing includes a broad range of strategies with one thing in common: the investor tries to predict future price movements and buys or sells securities accordingly.
These strategies involve active investment and are generally applied in the short run by setting rules that prescribe when to buy and sell according to specific signals, be them technical (related to price movements) or fundamental (hints that an asset is possibly momentarily under- or overvalued).
All the countless market-timing strategies out there rely on the assumption that markets can be predicted based on past data, even though financial theory rejects this hypothesis, stating that, in an efficient market, current prices already reflect all past information, so past data can’t say anything about the future.
Of course, in reality, markets are not always efficient, leaving room for some of these strategies to occasionally work in the short run, given one has superior prediction methods. However, there is evidence that they don’t beat buy-and-hold strategies over the long term in most cases. Therefore, unless you’re a seasoned professional investor with sophisticated tools to make market predictions, you’ll probably achieve better results by sticking to a buy-and-hold approach.
Combining the two
If you want to enjoy some active investing without risking deviating too much from the results that a passive strategy can generate, you could opt for a core-satellite approach, which is a combination of buy-and-hold and market-timing.
This method consists in dedicating the core of your portfolio (usually around 80% of it) to a long-term buy-and-hold strategy while using the rest of it (the satellite part) to try and chase higher expected returns by attempting to seize momentary occasions in the short term.
The satellite section of such a portfolio can also be used to achieve greater diversification than the core asset allocation would allow, for example by investing in peripheral markets or niche sectors with high growth potential but high risk.
Whichever approach you choose, BUX Zero offers you a selection of ETFs suitable for any investment strategy, allowing you to trade them without commission. Take a look at them here.