The stock market is a device for transferring money from the impatient to the patient. - Warren Buffett

Advantages of long term holding

A common theory is that investing long term is a cure all for removing risk, this is not entirely true, the economy can change dramatically in a few years, and unless you know what the economy will be like in 40 years you have to be really careful. Skilled long term investors take this into account and always try to buy very undervalued companies with very strong business franchises able to weather out any financial storm and increase their earnings per share over time. Look for invincible companies that will probably still be here in 40 years in one form or another and you are half way there.

That said, you should still watch your shares like a hawk. Read the company reports, subscribe to a good financial review magazine such as BRW and pay attention to any comments by the chairman, news on acquisitions and changes in management. Even the bluest of the blue chip companies make blunders and go broke from time to time on some folly by management, this doesn't mean buying a Newspager and watching the daily fluctuations in price and having a heart attack at every little dip, but stay on top of the company's situation and you reduce your risk dramatically. Knowledge and attention are the best risk management tools of them all.

The only factor you should not pay much attention to is share price volatility. Nothing is more contrary to the principles of intelligent investing than buying something because it has become more expensive or selling something because its price has fallen. Monitor the company, the balance sheets, the management and the company's primary markets, but try if at all possible to ignore the share price as best you can.

One reason to invest long term is because of tax advantages. While tax benefits seldom outweigh good investment choices, the imposition of capital gains tax favours a long term investor. The reason for this is that you only become liable to pay CGT when you sell your shares. If you don't sell your investment you never become liable for the CGT, that money stays invested and continues to compound. If you sell often you have to keep paying tax every single year. Money you could have working for you in the market goes in tax instead. A CGT liability is like an interest free loan from the tax office that you may never have to pay back or could simply defer as long as possible. This is not a negligible effect.

There is another argument for long term holding that doesn't even involve taxes. Brokerage is fairly expensive, even for discount brokers. The more often you trade the higher your costs in that will be. Many traders pay thousands of dollars a year in brokerage.

Another expense of trading is the spread between the bidding and asking price of a stock. For large stocks the bid might only be a cent or two but for very small stocks it can be considerable, 20% or more in an irregularly traded mid-cap stock and hundreds of percent in the really thinly traded speculative stocks. Every time you buy a stock you have to make the highest bid at that time to buy. When you sell you need to make the lowest offer for your sale to go through. This expense, part of "slippage" can be substantial. Every time you trade you may well lose 5% or more of your portfolio to trading expenses. In all there are actually no advantages to short term holdings apart from speculative trading. The number of people that make good money in investing outnumber the number of people that make good money in trading by an enormous margin. Taxes, brokerage and the spread make it just that much more difficult to make money by trading. These things have almost no impact on long term investors.

So do people tend to hold for the long term? Well according to the Brandes Bulletin, Winter 1994/95 edition, citing a study by Dunbar Financial Services the average holding time for US investors in a growth oriented no-load mutual fund is only 17 months. This is despite the (sensible) conventional wisdom that managed funds are best held over many economic cycles.

Timing success rates

A study of 100 large US pension funds found that while all engaged in a degree of market timing, not one gained an advantage from it. In fact, 89 of the 100 actually lost as a result of their attempts to time the market, incurring an average loss of 4.5% over a five year period from doing so.

The authors of this study (Jerome B. Bohen, Edward D. Zinbarg and Arthur Zeikel, Investment Analysis and Portfolio Management, Homewood, Il; Irwin, 1987) concluded:

The evidence suggests strongly that mutual funds as a group are not successful at market timing activities. We believe the same would hold true for other groups of institutional investors, measured as a whole.
Now of course many readers won't be terribly put off by this comment, after all they are small amateur traders, not institutional investors! Nevertheless the burden of proof lies on the person claiming the ability to beat the market, where are all these wealthy amateurs making big money as market timers? They certainly must be equally adept at tax evasion because one thing that is certain is that the ATO very rarely encounters some old millionaire who made his money as a trader, but there are a surprising number of such guys out there who are long term holders. If you want to know which group tends to die with the most wealth, traders or investors, just ask an estate lawyer!

The costs of trading

Bear in mind - this is a critical fact often ignored - that investors as a whole cannot get anything out of their businesses except what the businesses earn. - Warren Buffett

If a group of people were to sit in a room and run their own little market, bidding for and selling some sort of security to each other, on aggregate the profits and losses made would be equal. Some would walk away wealthier, having been more shrewd or lucky than most, and some will have lost money to the others. This might lead to a certain amount of wealth transfer, but no wealth creation at all.

Now repeat the exercise, except that somebody acts as a broker and takes $20 from the buyer and the seller every time a transaction is made. The story would still on average be the same, no money will have been made or lost on average, except that a few lucky traders will have taken the money of the others, and of course the broker will have made a large profit. If you looked just at the trader's accounts though you'll see that the traders as a whole had lost money, there was a net transfer of money from traders to the broker.

If you look at this in terms of a game theory approach you will see that trading is thus a loser's game, which means that there is no real way to win the game by skill and that the ideal strategy to maximise the wealth of the traders on average would be to do no trading at all, and thus have to pay less to the broker. The ideal strategy for a broker would of course be to encourage a lot of turnover, because every time somebody wants to make a trade the broker gets wealthier.

So trading itself generates no wealth at all. Remember if you will that there is a driving force behind share returns (retained business earnings + dividends) and property returns (inflation driven appreciation + rent) that does give an amount of profit to all holders. If every investor in shares and property were to hold their investments indefinitely, the amount of profit that would be realised by all investors would be equal to these investment profits minus tax. As soon as you start to introduce transactions the amount of profit that is made will be correspondingly reduced, to the profit of brokers, market makers taking the spread between bid and ask prices, taxes that are higher than they need to be due to regular capital gains events and all the other costs.

This is why so few people actually made any money at all in the Internet stock boom of the late 1990s, turnover for most Nasdaq stocks was simply staggering. The following table, taken from How to Pick Stocks Like Warren Buffett by Timothy Vick (the best Buffett book available, in my opinion) really tells a story. Vick estimated the costs incurred by traders as they rapidly flipped their favourite stocks. Making conservative assumptions about brokerage rates and bid/ask spreads but ignoring taxes, Vick compared the earnings of the top traded companies with the amount lost to brokers and market makers. The table goes on for two pages and lists lots of stocks, but here is the top ten from his list as at February 2000:

Stock Shares (million) Annualised Volume
(million)
Turnover ratio Transaction costs ($million) Estimated company
income ($million)
Yahoo! 398.0 4301.8 10.8 $796 $155
Rite Aid 258.9 1178.0 4.6 $218 $65
Peoplesoft 268.5 1033.9 3.9 $191 $62
Seagram Ltd. 432.6 278.9 0.6 $52 $17
Comcast 751.9 1261.7 1.7 $233 $83
Bethlehem Steel 131.5 315.4 2.4 $58 $24
America Online 2201.8 9763.2 4.4 $1,806 $771
Homestake Mining 228.0 420.0 1.8 $78 $34
Cabletron Systems 172.2 663.0 3.9 $123 $62
Network Appliance 145.7 535.3 3.7 $99 $60

The rest of the list contained a variety of well known companies, like Novell, Oracle, Seagate Technology, Baker-Hughes, Mattel, Sun Microsystems, Dell Computer, National Semiconductor and Compaq computer. By the time he got to the bottom of the list the income at least exceeded the brokerage expenses, but all companies mentioned had turnover so high that brokerage consumed between a third and five times the total profits made by the company. If each of these investors had simply sat and held on to their stocks as a group the investors in these companies would have increased their profits by hundreds of percent!

Risk reward ratios

If you are very interested in the subject of risk, a good book on the subject is Nassim Nicholas Taleb's Fooled by Randomness. He approaches risk in a very interesting manner quite different to the standard volatility based definition used by academics, yet not at all from the security analysis viewpoint used by Buffett et al.

Taleb contends that over relatively brief periods, return increases proportionally with time but risk increases more slowly, as the square root of time. This means that the risk reward ratio becomes increasingly favorable the longer your time horizon.

Over shorter periods, the risk reward ratio is terrible. If stocks return an average of 10% a year, with a 20% standard deviation, then over a year of trading days (260 days) the average return works out to be about 0.0367%, and the standard deviation to 1.24% (20%/sqrt(260)). By considering the laws of probability this means investors should expect a positive return only 51.2% of the time. (NB, this isn't quite true as up days and down days are not distributed according to standard statistical models, but reality is close enough and Taleb's point isn't changed materially).

Time horizon
Expected
return
Standard
Deviation
Probability of
positive return
Risk reward
ratio
One Hour 0.005% 0.438% 50.420% 87.6
One Day 0.037% 1.24% 51.2% 33.8
One Week 0.183% 2.77% 52.6% 15.15
One Month 0.797% 5.77% 55.4% 7.24
One Year 10.0% 20.0% 69.1% 2.00
Ten Years 159% 63.2% 99.4% 0.396
100 Years 1,378,000% 200% 100% 0.000145142

These aren't really reliable figures, the market does not behave in a neat manner according to the principles of statistics and the long term return has not necessarily been 10%, and the standard deviation of returns not necessarily 20%, but nevertheless I am sure you get the point. The longer you hold on to good growth assets for, the more likely you are going to have a positive return and the greater this return will be compared to the "risk" you take in getting it.

After I got my nifty new portfolio analysis software, I was able to calculate the actual risk reward ratios of the American S&P500 index over different time periods from actual data. From Jan 1926 through to June 2002, these were the actual risk reward ratios. (Software only goes into as fine detail as monthly data).

Period Return Standard deviation Risk/Reward Ratio
1 Month 0.99% 5.63% 5.69
1 Quarter 3.12% 11.57% 3.71
1 Year 13.66% 27.54% 2.02
5 years 52.79% 46.78% 0.89
10 years 214.23% 162.38% 0.76
20 years 746.34% 589.33% 0.79
30 years 1750% 300.77% 0.17

The remarkably high cost of trading and taxes

I wanted to work out just how big an advantage a long term investor has over a short term trader after taxes and fees. Making a spreadsheet up wasn't difficult and took me just a few minutes.

Using the following assumptions, which I think are all reasonably realistic, I found that longer term investors have a huge edge over shorter term ones due to their lower costs.

Long term capital gain rate 7%pa
Dividend yield 3%
% franked income 75%
Investor's marginal tax rate    48.5%
Cost to switch 1%

I worked out two things. First, I wanted to know how much money the various investors ended up with after investing $1,000 for 20 years in this manner, assuming that each were able to get 7% growth and 3% dividends (75% franked) before costs. I looked at the following frequencies: annually, annually plus one day so you get the 50% capital gains tax discount, once in 2 years, once in 5 years, once in 10 years and once in 20 years.

Trading frequency After tax end result
Once a year $2,675.77
Once every year + 1 day $3,687.14
Once every two years $4,114.56
Once every five years $4,505.15
Once every ten years $4,804.17
Once every twenty years $5,172.24

Next I wanted to see the kind of growth you'd need to get to compensate for your trading expenses. I have frequently heard traders claim that they can outperform the market substantially and that this compensates for their higher taxes. How much does a shorter term trader/investor need to outperform in order to compensate for their taxes and poor tax efficiency?

Trading frequency Capital gains required
Once a year 13.97%pa
Once every year + 1 day 9.44%pa
Once every two years 8.61%pa
Once every five years 7.92%pa
Once every ten years 7.47%pa
Once every twenty years 7.00%pa

Conclusion: you'd have to be a genius to outperform over the long term while operating on a short term basis. Capital gains tax and switching costs take away substantially from your long term accumulation. I haven't cheated by assuming very high brokerage, 1% switching costs is quite low as it includes market expenses. I also haven't bothered to work out how much you'd need to increase your returns if you switched multiple times a year. If you are one of those people that trade your stocks ten times a year then obviously you'd need to overcome that 1% switching expense ten times. I have great doubts that traders can recover those kinds of costs and maintain a good track record over the very long term.

My spreadsheet is cost_of_turnover.xls

One final point, you might be interested to read my quick summary of The Millionaire Next Door in the Thrift FAQ. This book points out that the majority of really successful investors are long term holders of growth assets like commercial real estate and stock.

If you want more info on this, go to the Trading FAQ, look at the article "Success rates of traders". I have cited a number of studies into the success of short term traders and investors.