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You Can't Afford This Huge Mistake

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Many so-called experts have proclaimed that buy-and-hold investing is dead. Yet if you start trading frequently instead of investing for the long run, you'll end up costing yourself a lot more than you may think -- and you'll dig yourself so deep a hole that you may never get out.

The perils of frequent trading
In all likelihood, you've already heard most of the arguments against short-term trading. Just in case you haven't, though, here's a quick summary:

  • Short-term traders pay a lot more in trading costs, such as commissions and other fees.
  • Short-term trading is essentially timing the market. If you don't time your entries and exits well, you can easily miss out on some huge profits as you wait on the sidelines.
  • Although stock price movements generally map well to the health of a company's underlying business over the long haul, they won't always behave rationally over short periods of time. That means that even if you guess correctly about a company's short-term prospects, the market may not accommodate you by pushing the stock price up.

If you'll notice, though, there are pretty good responses to each of those objections. When it comes to trading costs, for instance, the huge decrease in commissions that has come about thanks to discount brokers has made even frequent trading a lot more affordable.

Moreover, although market timers can end up watching from the outside as a stock rallies, they can also avoid riding their stocks down in a bear market -- something that many investors can appreciate, especially after their painful experience during 2008. And irrational stock movements can sometimes work in your favor, too. If you turn out to have been completely wrong about what would happen, the stock might still go your way.

But there's one disadvantage of frequent trading that you can't ignore. Unless you have access to a big enough IRA or other tax-favored account that lets you invest the way you want, then you'll end up losing much of your profits to every investor's constant enemy: the tax man.

Paying the short-term price
Every trade you make has tax consequences. When you own a stock for a year or less, the gains are treated as short-term, meaning you'll pay your ordinary income tax rate of as much as 35% on the money you make. In contrast, holding the stock for more than a year makes you eligible for the much lower long-term capital gain rate, which currently maxes out at 15%.

To illustrate the impact that taxes can have, let's take a simple if totally unrealistic example with two investors. One invests $10,000 each in several stocks for five straight years before selling them. The other invests the same amount in the same stocks but sells those stocks every year, incurring short-term tax, and then immediately repurchases the shares.

Because both investors essentially own the same stocks for the same amount of time in total, you'd think their results should be similar. But take a look:

Stock

Taxes Paid by Frequent Trader

Taxes Paid by Buy-and-Hold Investor

McDonald's (NYSE: MCD  )

$4,026

$1,947

Baxter International (NYSE: BAX  )

$2,897

$1,259

Colgate Palmolive (NYSE: CL  )

$2,130

$970

Southern Company (NYSE: SO  )

$915

$309

Chevron (NYSE: CVX  )

$2,085

$829

Procter & Gamble (NYSE: PG  )

$1,075

$461

Occidental Petroleum (NYSE: OXY  )

$5,816

$2,839

Sources: Yahoo! Finance, writer calculations. Assumes 35% rate for short-term capital gains and 15% rate for long-term capital gains.

Because of the higher rate, the frequent trader ends up paying anywhere from twice to almost three times as much tax as the buy-and-hold investor. Moreover, the taxes that the frequent trader pays every year along the way accentuate the difference. In the end, the buy-and-hold investor ends up with $15,000 more.

You can't catch up
Now obviously, if you're an active trader, you'll trade differently. You may buy and sell the same stocks, but you'll own them for certain periods and stay out of them during others, hoping to catch favorable price movements.

The point, though, is that to finish ahead, you have to overcome the big headwind from higher taxes. In other words, you have to be a great market timer. Even if you're slightly above average, then the tax hit will still wipe out your profits.

You're a lot better off not trying to beat that game. By investing for the long run, you may miss out on trading opportunities, but the taxes you save will usually more than make up for it.

Want to save more on your taxes? Check out this year's Motley Fool Tax Guide today for the help you need.

Fool contributor Dan Caplinger learned the hard way about the short-term trading trap. He doesn't own shares of the companies mentioned. Procter & Gamble and Southern Company are Motley Fool Income Investor recommendations. The Fool owns shares of Procter & Gamble. Try any of our Foolish newsletter services free for 30 days. There's no mistaking the Fool's disclosure policy.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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