Lately the rise of the “RobinHood Trader” has attracted a lot of Media attention. These brash young day traders have taken advantage of commission free trades to move in and out of stocks daily, or in some cases hourly. It looks like a lot of fun, and they claim to be making a lot of money. But is this a sustainable strategy for the long term? Financial Analyst Lee Rivers breaks down the math for us…
Investors have long debated the best strategy for profiting in the stock market. The two basic strategies of investors are an active and passive approach, with passive investors subscribing to the “buy and hold” method, while active investors preferring to buy then sell stocks frequently, known as trading. There has been an increasing amount of interest in trading, with the elimination of transaction fees for many brokerages. Trading is difficult to do successfully because of the costs beyond transaction fees, however, through taxes accumulated on realized stock gains, known as capital gains tax. The capital gains tax rate is the same as the income tax rate, 22% for the median U.S. income of $60,000, but only if the stock is held for less than a year. By holding a stock for more than a year, the capital gains tax is decreased to only 15% for the same tax bracket. A difference of 7%, or approximately $700 of $10,000 in capital gains. This benefit is even greater for the highest tax brackets, with an income tax rate of 35% for individuals making $207,350 or more and 37% for individuals making $518,400 or more annually both being decreased to 15% and 20%, respectively, with the lesser long-term capital gains rate. This results in a difference of 20% and 17% in the capital gains rate for each, translating to approximately $2,000 and $1,700 for $10,000 in capital gains. With greater capital gains these amounts increase substantially, with a difference of $20,000 and $17,000 for $100,000 in capital gains.
Furthermore, by trading, the investor is exposed to capital gains tax each time they sell for profit, known as realizing their gain. Therefore, a trader in the median tax bracket (22%) who makes 30% capital gains on $1,000 through two trades over a year will have an after-tax profit of $234, whereas an investor that held a stock for a year with a 30% gain would experience an after-tax profit of $255. A small difference in magnitude in this circumstance, but the difference becomes much larger with greater amounts of capital gains and at higher tax brackets. These relatively small percentages also compound quickly over time.
This also ignores the difficulty of trading. Burton Malkiel, the author of A Random Walk Down Wall Street compares those who frequently trade, known as day-traders, to gamblers since short-term stock price changes are unpredictable, thus coined a random walk. Day trading is consequently speculation as opposed to investing since it is baseless, ignoring the characteristics of a business or industry. It has been shown in studies performed by Duke that even market-timing professionals, meant to determine the short-term movements of stocks, are unable to effectively predict short-term behavior of the markets. Ben Graham, the mentor of the famous Warren Buffett, notes in The Intelligent Investor that studies have also shown that trading based on the previous movements of stocks, buying those that continue to rise and selling those that continue to fall, known as momentum investing followed by a group called Dow Theorists, underperforms buying and holding over the long term.
An additional benefit of buying and holding stocks is the compounded gains over a long period. The perfect market-timing investor in the 20 years from January 1, 2000, to December 31, 2019, that avoided the 40 days with the largest losses in the stock market would have experienced a gain of $242,117.29 on an initial investment of $10,000, or an annual return of 17.51%, versus an overall gain of $22,192, or an annual return of 6.02%, for Standard & Poor’s benchmark of the top 500 stocks (S&P 500) over the period as a whole. The failed market-timing investor that missed the best 40 days instead of avoiding the worst would have been left with a mere $4,615.42, or 124% less than buying and holding the S&P 500. This is an annual loss of 3.79%. Effectively timing the market over 20 years is impossible based on the random walk theory, however, in buying and holding, there is an almost guaranteed probability of a long term gain that will compound exponentially over time, whereas trading may result in significant losses. Continuing to hold the $10,000 invested in the S&P an additional 30 years beyond 2020 at 6.09% will result in a total gain of $182,185.32. A chart of compound growth for $1,000 is available here.
Many stocks, although a limited number in the biotechnology sector, also provide quarterly payments to investors, known as dividends. These dividends can be reinvested into the equities to contribute to the compound growth in potential gains. Using a $10,000 initial investment in a stock at $10 with an annual dividend of 5% or $0.50, that does not grow, but the share price grows annually by 6%, at the end of 20 years the total gain without dividend reinvestment would be $42,071.35 or 7.45% annually, versus a total gain of $56,403.72, or 9.03% annually with reinvestment. Reinvesting dividends thus led to a 34% greater total gain in value, the result of 758.69 additional shares accrued over the 20 years. These additional shares would also result in $379.34 in surplus annual dividend payments added to the $500 provided by the purchase of the initial 1,000 shares. A growing dividend increases the potential for value growth further.
Minimizing Risk – Maximizing Potential
The potential for losses through buying and holding is less than trading, but not eradicated. By purchasing and holding stock, the stock’s price may decline substantially from the time you invested in it, but rather than selling at a guaranteed loss, there is still potential for the stock to return to its previous price point and become a profitable investment. For example, buying Standard and Poor’s Biotech ETF (XBI), a collection of stocks in biotechnology, in August of 2008 at $22.91, but selling it directly after it dropped to around $16 in November would have resulted in a loss of nearly 30%. To recover that loss, the investor would have to return 40% on the remaining portfolio to break even, since the investment portfolio has decreased by 30%. However, if the investor buys the ETF at the same time, then holds it until June of 2020, the investor would experience a total return of 394%, or an annual return of 14.3%. Despite purchasing at a relatively high price in the short-term leading up to the 2008-2009 financial crisis, the investment provides excellent returns over the long-term period of 12 years. Thus, buying and holding reduces the potential for losses, benefitting from the development and growth of companies, and the economy over time.
Furthermore, the use of dollar-cost averaging, or purchasing additional shares every month, quarter, or year, can also increase potential returns and take advantage of short term declines in stock prices throughout a significant market crash. By investing an initial amount of $10,000 in the Biotech ETF XBI in August 2008 and purchasing an additional $100 a month to June 2020, the total value would have increased to $101,482 or an annual rate of return of 21.64%, excluding dividend reinvestments. Dollar-cost averaging is particularly valuable in an industry as volatile as biotechnology.