Is it really best to buy and hold stocks, or can you do well trading more frequently? Well, to most of us at Fool HQ, buying stock in great businesses with the aim of holding on for years (if not decades) seems to be the most compelling way to accumulate wealth. But this is easier said than done. When the stock market is surging or plunging, or when you learn of one exciting company after another, it can be hard to refrain from actively buying and selling.
The buy-to-hold message is further challenged by the likes of day traders, who believe they can wring extra profit following the stock market by the hour. (Of course, within a few weeks or months, many of them have completely washed out.) In addition, full-service brokerage firms on Wall Street have benefited by encouraging customers to trade frequently. (The firms take a cut of every trade via commissions. The more you trade, the more they profit. Not a great equation.)
Brad Barber and Terrance Odean, professors at the University of California at Davis business school, hammered another nail into the frequent-trading coffin with their research. They published papers demonstrating that individual investors who buy and hold generally outperform those who trade frequently. (Here's their study.)
Barber and Odean studied the trading of more than 60,000 households with accounts at a major discount brokerage from 1991 through 1996. They learned that the average household had a net annualized geometric mean return of about 15.3%, compared with a market gain of 17.1%. Bummer. Even worse, the fifth of the households that traded most often realized merely a 10% yearly gain.
The professors concluded that these folks were losing to the market because they were trading too much. The average household turned over, or "churned," 80% of its stock portfolio each year. This means that a portfolio valued at $10,000 had $8,000 worth of stocks bought and sold during the year. We're not talking small-potatoes expenses here; things such as commissions and capital gains taxes will take significant bites out of these investments.
The lesson is clear: Investors who think of themselves as committed, long-term owners of businesses are much more likely to generate enviable returns than are the active traders who try to time the market by rapidly moving in and out of stocks. In Barber and Odean's own words, "[Frequent] trading is hazardous to your wealth."
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