Trading Secrets of the Super-Rich

Ever wonder how rich folks trade?

I don't mean hedge funds and the like. I mean the real rich, people with inherited wealth who don't have to spend their days huddled over computers in order to earn a living. They can hire the best help and advice out there -- they must be cleaning up, right?

Pick up any issue of Barron's, and you'll see a few ads for trading "services" -- tutorials, tip services, gurus, etc. -- that promise spectacular results for those who apply themselves to learning the art of short-term trading. If those sorts of things are available to every Joe and Jane on the street with a few thousand bucks to spend, what do you think the really rich folks are doing?

I'll tell you what they're doing: Nothing.

The real secret of trading
Here's the real secret of trading: Most people who try it lose money. That was true a decade ago, when Brad Barber and Terrance Odean, business school professors at the University of California at Davis, published an important study showing that frequent trading was "hazardous to your wealth." If anything, it's even truer nowadays, with new technology giving professional traders an overwhelming advantage over individuals.

So why do ordinary investors do it? Barber and Odean concluded that overconfidence was a key factor -- people overestimated their ability to pick market-trouncing stocks. But I think there's another factor at work, one that comes to light when you compare the trading behavior of people who are building wealth with those of the folks who already have wealth: Simply put, some people are trying to wring more from the market than it has to offer.

Motivated by stories of outrageous returns, these folks aren't content turning their $100,000 nest egg into a million over 20-plus years. They want to do it by next year. And so they take the courses and subscribe to the trading tip lines. And usually they end up underperforming their neighbor's index fund by several percent -- if they don't manage to lose all their money.

Meanwhile, over on Easy Street...
By now, it should be clear that the "trading secret of the super-rich" is to trade as little as possible. Most rich folks are just buying and holding. And often, they're holding for decades. I know of one wealthy family whose stock portfolio consists entirely of a few blue chips -- Pfizer (NYSE: PFE  ) , JPMorgan Chase (NYSE: JPM  ) , Altria (NYSE: MO  ) , ExxonMobil (NYSE: XOM  ) , and a couple of others.

Most of their stocks were inherited from an ancestor who simply bought stock in the companies he admired and did business with a couple of generations ago. The dividends paid by these companies provide a great income stream, and as long as that income stream continues, the family won't have any incentive to sell. That's their complete stock investment strategy. In fact, it's entirely possible that the family's descendants will still hold the same stocks 50 years from now.

But what about us?
Sitting on Grandpa's dividend-paying stock portfolio is a fine approach if your goal is to preserve wealth and generate an income stream. And building your own is a pretty good approach if you want to build wealth, particularly if market volatility makes you nervous. How so? Instead of taking those dividends as income, reinvest them -- use them to buy more stock.

The practice of reinvesting dividends can turn boring performance into market-beating returns, partly because dividend-paying companies tend to be stable and mature. At first glance, that may appear to be a mixed blessing: good because they're much less volatile in choppy markets, bad because they're less likely to rocket to 10-bagger levels of return. But they'll show solid growth over time, and combined with the power of dividend reinvestment, a well-chosen portfolio of dividend-paying stocks has a great chance of outperforming the market over the long haul.

In the meantime, if you're tempted to pore over your stock holdings every minute, do yourself a favor -- don't. You may be surprised how much better you do as a result.

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