If you are a regular reader to my blog, I recommend a buy and hold strategy when it comes to investing. You should invest in low cost, high quality mutual funds and avoid selling until you need the money. Be happy with earning with what the market returns because it is nearly impossible to outperform the market consistently over time. There are many others out there that still preach about buying and selling on a regular basis to earn a higher return. However this approach is flawed.
Why You Earn Less When You Trade
To begin, let us say you are invested in a stock that has earned you 15% over the past year. You decide to sell because you think the stock has run its course and now are going to invest in another stock. Here is what is working against you in this scenario:
- If you sell, you will owe a commission on the sale
- If you sell, you will realize the 15% gain and owe tax on that gain
Because of both of these events, your 15% return was just lowered by taxes and trading fees. On top of that, there is one more issue: you have to find a better performing stock. There is no point in investing in a stock that earns less than 15% because you will be worse off than had you held on to the original investment. You cannot just earn 15% either because that would mean you are still worse off because of the taxes and trading fees you paid. So, you have to earn more than 15% on your new investment. And let’s not forget that you will owe a trading fee when you buy the new investment.
You Can’t Do This Consistently
While you could make that case that you could sell a stock that returned 15% and find a better performing stock, you can’t make the argument that you can do this over and over, time and again over a long period of time. It just cannot be done. Bill Miller of Legg Mason beat the market from 1991 to 2005. The odds of doing this again: 1 in 2.3 million. You will eventually invest in a dog and lose money or not earn as well of a return. As a result of this, you are in a worse situation than if you had just bought and held.
The Numbers Speak for Themselves
A professor at the University of California at Berkley conducted a study and found that those that traded on a regular basis earned 2.65% less than if they had just left the investment alone (i.e. buy and hold).
Take this example: if you invest $200,000 and earn 8% over 15 years, your investment will grow to just under $692,000. Take the same amount over the same length of time but only earn 5.35% (8% less the 2.65%) and you wind up with a little more than $454,000 which is a difference of $238,000. That is a serious chunk of change.
It seems as though trading stocks is the way to go. After all, that is what CNBC and personal finance magazines tell you. But they have to sell advertising space and need something to talk about each day. If they told you to buy high quality, low cost funds and let them ride, what would they talk about for the other 364 days of the year? Unfortunately, long-term investing is boring if you are looking at it from the perspective of having to spend time on your portfolio everyday. This is because when you buy for the long-term, you don’t have to constantly monitor and adjust your portfolio.
If you still find yourself having the itch, then you can open up a small “play account” where you can trade all you want. Just make sure you leave the trading in that account and not let it spill into your long-term investments.