Buy and hold investing is a time-tested passive investment strategy.
However, perhaps due to the influence of modern technology enabling easier access to the stock market, buy and hold investing seems to be less popular with investors these days.
That is a shame.
Holding Times Are Getting Shorter
Investors are holding stocks for shorter and shorter periods of time.
While actual hard data is always hard to come by, I have seen one estimate that in the early 1940s the average investor held a stock for 7 years, according to data from the New York Stock Exchange.
As of 2014, the average holding period of stocks by individual investors may now be as little as 17 weeks, according to data collected by Jason Zweig.
There is little doubt that this is not due to brokerages or high-frequency trading by machines alone. It seems clear that individual investors are also holding for shorter and shorter periods of time.
I believe that modern technology has helped to enable this behavior and the results are stunning.
Fortune Favors The Forgetful?
Although anecdotal, there was also a fascinating story given in an interview that I just have to repeat here.
James O’Shaughnessy, the author of the book What Works On Wall Street, was being interviewed by Barry Ritholtz on the Masters in Business podcast on August 30th, 2014.
O’Shaughnessy mentioned a study Fidelity had done to find out which of their clients’ investment accounts had performed the best.
What they found was that the accounts that had done the best, were the accounts of people who had completely forgotten that they had an account at Fidelity.
Let that sink in for a minute.
In other words, those who traded the least, performed the best.
Now, I’ve seen this same story embellished elsewhere, often by authors who failed to link to the original podcast interview. (You can find a link below.) While some bloggers have claimed that the account holders were dead, that is not actually what James O’Shaughnessy said in the interview.
It appears that the study in question might have been internal, as despite repeated attempts, I’ve been unable to find a copy of it anywhere. In order to clarify the situation, I’ve even reached out to Fidelity directly and will provide more information if I receive a reply.
Trade More, Make Less
To be honest, even if the original study by Fidelity is never found, or at worst never even never took place, it would not diminish the underlying moral of the story.
Part of the reason the anecdote gained so much attention, was because it merely echoed what has already been known for a long time. There is an abundance pf academic evidence showing that indeed, those who trade more, make less.
Terrance Odean of the University of California, Berkeley, in a landmark research paper titled Do Investors Trade Too Much?, examined the data from a discount brokerage of over 10,000 individual investors over a seven-year period.
Odean found that if investors sold one stock and then bought another, the initial stock the investor sold generally outperformed the stock the same investor later bought. Even when trading costs were ignored, investors still lowered their returns by excessive trading.
It is important to keep in mind that in the real world, if those stocks were not held in a tax-free account, those same investors would also have had to pay taxes on any gains each time they sold a stock, which would have further hurt those investment returns.
In another paper titled Trading Is Hazardous To Your Wealth: The Common Stock Investment Performance Of Individual Investors by Terrance Odean and Brad Barber, the authors found that the investors of 78,000 households were not only overconfident in their abilities, but again that the more often the investors traded, the poorer their returns were.
It is quite clear from repeated studies of the actual investor performance, that those who traded the most, performed the worst.
There are various costs that are must be taken into account when buying and selling stocks that ultimately hurt investment returns.
Logically, it should be easy to understand that the more money you spend, the more damaging it will be to your investment returns. However, many investors seem to turn a blind eye to many these costs.
Let’s take a look at a few of the fees that investors incur.
Trading costs money. It isn’t free.
Brokerages have expenses that have to be covered and in order to do so, most brokerages charge commissions to account holders each time a stock is bought or sold.
Much like the old proverb that says that “the grass is greener on the other side of the fence,” the stocks others hold often look better than the ones we currently hold.
Unfortunately, there are many investors who sell their stocks and then buy other stocks, repeatedly churning their investment accounts in the process, all the while running up fees and hurting their returns.
A discount online brokerage may charge anywhere from $5 to $15 dollars per trade, while an expensive full-service brokerage may change up to $100 to $200 per trade.
Even at the low end, a diversified portfolio of 10 stocks would cost at a minimum $50 to buy, and them another $50 to eventually sell those stocks.
The bid/ask spread is the difference in price between the bid, the highest price a buyer is willing to pay for a stock, and the ask, the lowest price the seller will accept to sell a stock.
When a market order is fulfilled, the difference between the bid and ask price is the profit that the market maker receives. These market makers help keep the stock market running efficiently by buying, holding, selling, and matching orders for stocks.
The smaller or more thinly traded the stock, the higher the bid/ask spread will be, and the fewer number of shares you buy, the greater the impact will be.
Let’s say that you want to buy a stock trading at that currently trades at $20. If you placed a market order and the order was filled at $20.50, fifty cents higher than you had planned to spend, then you would lose $.50 or 2.5% of your money
Although sometimes said to be hidden, the bid/ask spread is a real cost that adds up over time when buying or selling stocks.
Cost Of Margin
Margin, is the borrowing money to try and improve stock investment returns, which not only substantially increases risk, but again, also costs money.
Margin is generally used by short-term traders. Long-term investors usually avoid using margin as over a long period of time a greater return would be needed just to break even.
Interest is usually charged daily and the rate is usually higher for smaller loans. For example, at the time of writing, Scottrade’s interest rate was 8% on a loan balance of under $10,000 U.S.
Win or lose, the brokerage will charge money for loaning money to an account holder and the stock in the account is held as collateral.
Although not recommended, if you choose to use margin, it is important to understand that those costs will also lower investment returns.
Death And Taxes
Two things are certain: death and taxes, as mentioned by not only Daniel Defoe (1660–1731), but also later by Benjamin Franklin (1706–1790).
If you sell your stock for a gain, if it isn’t in a tax-free account or if you don’t live in a country where there are no capital gains taxes, then you are going to have to pay taxes on that gain.
One of the benefits of holding for the long term is that holding delays the the need to pay capital gains taxes, as capital gains taxes only apply when the investment has been sold.
For example, in the United States, as of 2015, short-term capital gains are taxed as ordinary income. For example, if you are in the 25% tax bracket, then you must pay 25% of any income and short-term capital gains made during the year.
However, if you hold a stock more than one year, then long-term capital gains tax rates apply. For someone in the 25 to 35% tax brackets, then the capital gains tax would be 15%.
Even if you are lucky enough to be wealthy and fall into the 39.6% tax bracket, then the capital gains rate would still only be 20% if held for more than a year.
From a tax point of view, in the U.S. it is almost always preferable to hold your stocks for more than one year and be taxed at a long-term capital gains tax rate.
Now let’s think really long term.
If you buy a stock and let it grow for 20 years or more, you only pay capital gains tax at the very end when you sell the stock.
Better yet, imagine you are retired at that time, with less income, that would most likely put you in a lower tax bracket with an even lower long-term capital gains tax rate. There are some very real benefits of holding stocks for the long term.
The less tax you pay, the more money ends up in your pocket, and the tax rates in the United States at least, favor the long-term investor.
Investors like Warren Buffett and Charlie Munger are famous for holding stocks for the long term and reaping these kinds of tax benefits.
However, even here on this blog, we have profiled everyday people like Grace Groner of Lake Forest, Illinois and Ronald Read of Battleboro, Vermont who held their stocks for decades, became rich in the process, and benefited from preferential long-term capital gains tax rates.
Time Has Value
“Time is money,” as Benjamin Franklin once wrote. Time has value. You can spend time, but you can’t get it back. Once time is gone, it is gone.
There is an opportunity cost in that there is only so much time in a day. Spending time doing one thing most often means not doing another.
Passive income is all the rage now, but investing isn’t passive if you sit in front of a computer all day trying to eke out a living by day trading.
This is one area where long-term investing really shines. You can spend your time working and earning more money, or even spend the time relaxing with your family, while you investments work for you.
The less work you put into investing, the more passive any income generated becomes.
Life is busy enough as it is. Who wouldn’t want to spend more time enjoying life than sitting in front of a computer screen?
Let Winners Run
Personally, I generally try not to sell my stocks. I try to let my winners continue to make gains.
Every time I think about selling, I try not to think about the gains that I’ve made, but instead I try to think about the gains I’m possibly about to lose out on by selling the stock.
Think about it this way, if the company’s management has been conservative in their actions and the intrinsic value of the firm has risen, then there is a good chance that you have picked a good company to invest in.
You also most likely know more about the company that you’ve been a stockholder of, than a new company that catches your interest.
Moreover, every time the price of a stock doubles, the next double becomes even easier.
For example, after a 100% gain, only a 50% gain is needed for the stock price to double again. After a 200% gain, just a 33% gain will cause the stock price to double once more.
As the price of a stock rises, only a smaller and smaller amount of gain is necessary to lead to more substantial returns on your investment.
All else being equal, and assuming the company has good management and more growth ahead of it, the math clearly favors holding a stock for the long term, rather than selling it and purchasing another stock.
Hold For The Long Term
There are many advantages that favor holding stocks for the long term.
Those advantages include fewer fees and commissions, preferential tax treatment, ease of increasing gains, not to mention less time spent in front of the computer.
Hold for the long term. It is the academically proven way to improve your investment returns.
The less you trade, the more you make.
Fees hurt investment returns.
Deferring taxes until later is preferred.
Let winning stocks run.
Time is money.
Duration Of Stock Holding Periods Continue To Fall Globally
Why Hair-Trigger Traders Lose The Race
5 Things I Learned On The Way To An 1,100% Return On Netflix Inc. Stock
Trading More Frequently Leads To Worse Returns
Do Investors Trade Too Much? (PDF)
Trading Is Hazardous To Your Wealth: The Common Stock Investment Performance Of Individual Investors (PDF)
Masters In Business: James O’Shaughnessy
In Praise Of The Dead (Investors)
Comparing Long-Term Vs. Short-Term Capital Gain Tax Rates