We at The Motley Fool have never been proponents of frequent stock trading. Generally, investors should buy the stock of a company only if they can hold on to those shares for a few years. Why? Because in the short term, stocks can be very volatile -- the prices of individual shares can drop 10% or more in a heartbeat.
However, some investors wonder whether buying and selling stock frequently would be so bad if they limit themselves to relatively stable blue-chip companies. It's a fine question. And here's my take on an answer.
First off, it's not always easy to discern exactly what is or isn't a high-quality, blue-chip company. Even big, established names such as Nike (NYSE:NKE), Coca-Cola (NYSE:KO), and Gap (NYSE:GPS) can experience protracted slumps. In the short-term, you're never guaranteed smooth sailing.
Let's examine the disadvantages of trading frequently. Imagine that you bought $10,000 worth of stock in Librarian Supply Co. (ticker: SHHHH). It was a smart purchase -- within about 10 months, it has doubled and your shares are worth $20,000. You have a choice: You can continue hanging on, or sell and buy something else.
We'll assume that you're still bullish on SHHHH, but that you also have high expectations for Claudius' Tye-Dyed Togas (ticker: TOGAZ). Let's also assume that your expectations are correct -- both will end up doubling within a year! Here are two possible scenarios:
- You hang on to your SHHHH shares and they double, becoming worth $40,000.
- You sell your $20,000 of SHHHH shares to buy shares of TOGAZ. Let's say that you're in a 33% tax bracket. That means $3,300 of your $10,000 gain will go to our friend Uncle Sam (unless you hold SHHHH for more than a year, in which case 15%, or $1,500, of your gain would likely go to Uncle Sam). Out of the $20,000 of shares you sold, you now have $16,700 to reinvest in TOGAZ. You do so, and within a year, it's doubled and is worth $33,400.
This should give you an idea of what happens when you trade frequently. Lots of trading generally translates to frequent tax payments -- and lots of brokerage commissions (which is why you should consider a discount broker). If you hang on to shares of a great company for decades, you will eventually sell and pay taxes (unless the shares are in a Roth IRA), but the overall hit will likely be lower than if you'd been steadily trading all along.
Of course, if you think that SHHHH has run its course or you no longer have any faith in its future prospects, then you should sell your shares. And if you think that TOGAZ will grow considerably faster than SHHHH, then selling might be smart.
To learn more about how to decipher financial statements and evaluate companies, check out our highly regarded How-to Guides and online seminars.
