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Why Buy & Hold Works and Trading Doesn’t

Posted By Jim On 03/11/2013 @ 7:00 am In Personal Finance | 6 Comments

Buying and selling stocks, like buying or selling anything, is fun. Buying and holding is not fun. Buying and holding for forty years is not only not fun, it’s boring. But, like broccoli and wearing your seat belt, boring is oftentimes good for you and in the case of your financial health, it’s very good for you.

The path to financial success is being able to make the right bets at the right time. For most of us, we have neither the funds nor the energy to study the markets well enough to make the right bets at the right time. Think back to any war story your friends ever told you about their trip to the casino. For every one tall tale of success, there are dozens untold stories.

I’ll give you an example. The most I’ve ever won in a casino was on a cruise ship a few years ago at the craps table. Craps is a lot of fun because it’s social in nature. After maybe an hour, I was up somewhere close to a thousand dollars. I walked away with the money in my pocket because, and this is one of the benefits of craps, we wanted to do something else and it’s hard to stand there for an hour. That’s a great story… except behind it are a bunch of stories where I sat down at a three card poker table and lost $200 in about 10 minutes. Or $100 in about 15 minutes at roulette.

The reality is that trading stocks frequently is a losing game and for every Apple success story (I bought shares at $90 and sold them at $560), there are a million other BPs and the like. We aren’t good enough at trading and here why:

You Have a Job

One of the hardest things about investing is that you have very little control over how much your investment make or lose. You control two things – 1) when you buy and 2) when you sell. This is in direct contrast to almost everything else in your life, including what typically is your number one source of income: your job.

If you have a job, chances are you have to do it on a daily basis and that means you can’t be watching the stock market when it’s open at 9:30am and when it closes at 4:00pm. You can’t be reading news all day, you can’t be studying charts, and you can’t be watching all the other things you need to in order to successfully “trade.”

You Have Emotions

The largest percentage gain by the Dow in the modern era (well, after 1935 anyway) were both in October 2008 when it popped 11.08% on the 13th and 10.88% on the 28th. Those are atypical, obviously, but these swings were close to a 7.87% loss on 10/15/2008 and a 7.33% loss on 10/09/2008. As you may recall, Lehman Brothers filed Chapter 11 on 9/15/2008 and the markets were a mess for a short period afterwards.

If you were invested in 2008, did you panic and pull your money? If you panicked, what are the chances you put your money back in just a few days later? 10/9/08 the market tanks 7.33% only to jump back up by 11.08% on 10/13/08.

Which leads to the next point…

You’re Not a Machine

You are not dispassionate like a machine. You’re not fast like a machine. You don’t have set rules like a machine. You cannot trade like a machine and a machine will eat you up. High frequency trading algorithms are eating your lunch right now [3] and make up the bulk of the transactions today.

Would you play a machine at chess for money?

You Don’t Have Enough Invested

How much do you have invested in the stock market right now? $10,000 is a lot of money in the real world, it’s nothing in the stock market. How much of a return do you need to make to cover transaction costs? If you use a discount broker and pay $5 a trade, you need at least a tenth of a percent of gain to offset the round trip transaction cost of buying and selling.

So now your bar is to exceed a single percent… let’s say you buy a stock and it goes up 10%. 10% is pretty good… that’s $1,000 on a $10,000 investment. You sell it and shave off that tenth of a percent to cover costs, you’re at $990. Now you pay short term capital gains (you’re in the 25% tax bracket), so you end up with $742.50 on a $10,000 investment. 7.42% isn’t bad… but was it worth all your time tracking? Can you repeat it?

I suspect not.

The reality is that investing for most of us should not be exciting. It should be boring so you don’t get tempted to do something stupid like chase an IPO (Facebook anyone?) or some other high flyer. Be excited by the other things in life and if you want to gamble, go to a casino… at least they’ll give you free drinks.

(Photo Credit: SalFalko [4])


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[3] High frequency trading algorithms are eating your lunch right now: http://www.nytimes.com/2012/12/04/business/high-speed-trades-hurt-investors-a-study-says.html?_r=0

[4] SalFalko: http://www.flickr.com/photos/57567419@N00/5961260280/

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