Still Better to Invest Than Trade

09/20/2012 10:00 am EST

Focus: MARKETS

George Putnam

Editor, The Turnaround Letter

When markets slow down, people abandon their long-term investing discipline and dive into the trading pool...but that isn't the answer to securing long-term success, argues George Putnam III in The Turnaround Letter.

We recently came across some statistics that we found quite surprising and, frankly, quite scary.

According to the New York Stock Exchange, the average holding period for a stock in 1960 was a little more than eight years. By 1980, it had dropped to a little less than three years, and by 2000 to a little more than a year. By 2010, the average holding period was down to about six months.

We’ve been hearing for a while that “buy and hold” is dead, but we disagree—at least if you want to make money from your investments. We strongly recommend being patient with your stocks for several reasons.

First of all, very few people, if any, are consistently good at picking the right time to get into and out of a stock. It is hard enough to find a good stock to own, and almost impossible to pick just the right time to buy and sell it.

You are much more likely to make money by identifying stocks with good potential and then giving them plenty of time to reach that potential. Computers might be able to execute a lot of short-term trades and actually make money at it, but it is very difficult for humans to do.

Another factor contributing to the difficulty in making money at short-term trading is transaction costs. Every time you get into or out of a stock, you pay a brokerage commission. And brokerage commissions are only part of the cost of making a trade. There is always a “spread” between the bid price (what someone is willing to pay for a stock) and the asking price (where someone is willing to sell the stock).

Moreover, if the stock is not actively traded, even a small transaction can adversely affect the price—i.e. someone trying to sell a stock will push the price down and a buyer will push the price up. The more you trade, the more all of these costs add up and reduce your return.

Next, taxes can have a significant effect on your profits. If you hold a stock for more than a year before selling, your gains will be taxed as long-term capital gains at a maximum federal rate of 15%. If you sell in one year or less, your gains are taxed at short-term rates, which can be as high as 35% at the federal level.

That’s a big difference in the amount of your profits you must share with Uncle Sam. And many states get their piece too.

Finally, many short-term traders miss out on the beneficial effects of dividends. Over the long haul, dividends can make up a substantial portion of your profits on many stocks.

For example, since 1926 dividends have made up approximately one-third of the total return on the stocks in the S&P 500. For some ten-year periods, it was more than half.

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