The canonical investing advice is to choose strong investments based on their fundamentals, buy them and then continue to hold them for a long length of time. The wisdom is that such investments will weather the short-term vicissitudes of the market, and over the timescale of many years, give consistent returns. Yet, one often hears about the tremendous potential for quick returns through buying and selling financial instruments over short spans of time, perhaps over months, weeks or even minute-to-minute. This is what professional traders, for example at hedge funds, often do.
Supposing that every financial instrument has some inherent value, based on its underlying assets, the goal of most short-term trading strategies is to spot those instruments that are trading at some other value and either buy or sell short, betting that the value will equilibrate. This is a form of arbitrage: seeking to profit from disequilibrium in the market. On the other hand, a buy and hold investment strategy is a bet not the price of a financial instrument will return to its true value, but that that the true value will increase; this strategy is the better one for the average investor for several reasons:
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Capitalizing on short-term market disequilibrium requires that such opportunities be quickly spotted and acted upon. For large financial institutions, this means developing sophisticated computer programs designed to cull through market pricing data in real time combined with the ability to move large sums of money into and out of the market at a moment’s notice.
The retail investor has none of these tools at his disposal: no proprietary software that took many man-years to develop, no time, at this scale, to commit to monitoring the market and no free cash-on-hand. Since there is a principle that arbitrage will drive the market towards equilibrium, investors who cannot immediately spot short-term opportunities will miss out on them.
By placing short-term bets on the movement of a stock or bond price, the investor hopes to realize returns through changes in the selling price of that stock or bond (capital gains). However, when one holds financial instruments on longer time-scales, one benefits both through appreciation in the instrument’s value and also through the payment of dividends, in the case of stocks, or interest, in the case of bonds. These dividends can then be taken as income or reinvested, compounding returns.
Capital gains taxes are paid on the difference in the value of a financial instrument between when it was bought and when it was sold, at the time of sale. Thus, the gains on a stock purchase and held for many years will only be taxed once, at the time of sale, e.g. retirement. On the other hand, if one pursues a buy and sell strategy, the gains are taxed each time they are moved out of the market.
If one were to buy and hold a stock that averaged a gain of seven percent per year over the period of 40 years, making an initial investment of $100 and selling at the end of that time, one would realize a gain of $1,397 and would pay a 15 percent US capital gains tax of $210 in the year of sale, leaving an after-tax gain of $1,187. If, on the other hand, one were to pursue a buy-and-sell strategy also averaging seven percent per year and making one trade per year, at the end of 40 years the after-tax gain would be only $1,009. This is the notion of the tax efficiency of investments, and is the rationale behind investing in IRA’s and other tax-differed accounts.
For all of these reasons, it is generally recommended that the average investor looking to realize stable, long-term gains adopt a buy and hold investment strategy, changing the balance of the portfolio only over large time-scales to account for factors such as changing risk-tolerance as retirement approaches.