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How to Be a Buy-and-Hold Investor

Free yourself from the tyranny of market swings.

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In investing, patience is more than a virtue, it's a necessity. If you trade a lot, you will run up increased costs such as commissions and taxes, thus driving down returns. In addition, you risk messing up your long-range plan by altering your portfolio's diversification among asset classes and sectors.

Yet, being patient and sticking to your plan is pretty difficult emotionally. I think the main reason is that we can't control our investments' returns, so trading them makes us feel like we're doing something and are really in control. In fact, making a lot of trades is a sign that you're letting the markets drag you around by the ear, but it feels better than sitting on your hands.

Those aren't the only emotions that get in the way of investment success. I hear from investors all the time about how they want to get into some superrisky area that's red hot, such as energy or China. When you read about others making a bundle in latest hot sector, you naturally feel greed and envy. If you also are naive enough to think that the good news isn't priced in to stocks or sectors by the time they hit the front page of your local newspaper, then you may well throw logic to the wind and dive in.

I've read that gambling addicts get hooked by making one really big winning bet. Maybe it works that way for investors. Say you bought an energy fund at the end of 2004. You were definitely late to the game, but oil prices kept going up and you'd have earned a nifty return anyway.

On the flip side, it's tough for investors to stick with a fund that is underperforming or has suffered a manager change. To be sure, there are times when you should get out. If the new manager isn't impressive or if a fund has suffered long-term underperformance, you might want to get out. However, too often investors sell on a temporary dip in performance just before a fund rebounds.

The key to avoiding these mistakes and becoming a buy-and-hold investor isn't so much about making a good call at the moment of indecision as it is about building a great portfolio with staying power at the outset. You need a plan, and you need funds whose strengths should still be around in five or 10 years. Here I'll focus on the fund selection part.

Look For Stable, High-Quality Management
A fund absolutely has to have more going for it than a good year or two of returns. You need outstanding managers and a culture that keeps them around. While individual investors tend to focus mostly on performance and less so on management, big institutions like pension funds and endowments devote most of their research efforts to management.

They focus closely on any departures of managers and analysts and the reasons for their departures. They even drill down to how investment professionals are hired and compensated.

Finding a fund with skilled management and stability will make it much easier for you to become a buy-and-hold investor. Check out a fund's track record of manager changes and that of other funds in the shop. If there's a lot of turnover, you may well be regretting your investment in a year or two. Too many fund companies have revolving doors on their manager suites and that makes for frequent strategy changes as well as changes in the quality of management. However, others have stability you can bank on. Consider firms like Dodge & Cox, American, Davis Selected, Primecap, Wellington, and others where analysts and managers generally stick around their whole career.

Choose Low-Cost Funds
Expenses are a good predictor of future returns because they are deducted from a portfolio's returns and because they don't change very much. Low costs will help cut the pain in a downturn and improve the gains in a rally. Over time, a low-cost portfolio will handily beat a high-cost portfolio. One of the advantages of being a buy-and-hold investor in low-cost funds is that you can watch your gains from low costs compound over time into a healthy sum.

Develop Realistic Performance Goals
All funds suffer years of underperformance. It's just the way things work. The bolder a fund, the worse its downside will be. A focused fund will have some years in which it's well behind the pack. An emerging-markets fund will have years in which it loses a fourth of its value--that's just the price of admission. If you appreciate that going in, you'll be better suited to riding out the tough years.

I own  Oakmark Select (OAKLX), which had a bad year in 2004 and a modestly subpar year in 2005. Am I worried? Nope. In fact, I'm buying more. True, the fund has a little more in large caps than it once did, but that's what I'd expect after a long stretch in which large caps have become cheaper than mid-caps. Nygren looks for companies trading at discounts to their net worth, and it makes sense he'd find more large caps that fit the bill. In summary, the manager is still there, he's still doing what he's done all along, and he's produced outstanding long-term returns doing so.

So, what would worry me? The biggest worry would be Nygren leaving. It's not a knock on others at Harris Associates, but Nygren was key to my buying the fund and has had more to do with the fund's success than anyone else.

Beyond that, I'd get a little worried if he abandoned his strategy or started to make big fundamental mistakes that eroded the fund's long-term performance. But that doesn't often happen at a fund where the manager has proved his abilities over a long period of time.

Conclusion
Last year very little happened to my portfolio, and that's by design. Outside of further contributions and rebalancing, I really only made one trade.  American Beacon Small Cap Value (AVPAX) replaced  Fidelity Low-Priced Stock (FLPSX) in our 401(k), so a small sum that I had in Low-Priced moved to the American Beacon fund, and that's about it. My funds' long-term prospects are just as good as they were a year ago, and I expect I'll still be holding most of them 10 years from now.

Shameless FundInvestor Plug to Follow
Readers of Morningstar FundInvestor know this philosophy drives our research and recommendations. We help subscribers to block out the noise and get right to the fundamentals that drive long-term performance. We also let you know about great undiscovered funds that haven't yet been swamped with cash as well as our favorites among the better-known old dependables. Finally, with our Red Flags column and pans list we tell you when it's time to bail out. For information on subscribing, click here.

Russel Kinnel has a position in the following securities mentioned above: OAKLX. Find out about Morningstar’s editorial policies.