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Reasons to invest long term

Why long term investment is better

We believe it is essential that investors take a long term view, and avoid trading. There are many reasons why we feel this way:

  • Long term investment is much more tax efficient
  • Long term investment costs less than short term trading and investment
  • Long term investment is lower risk

Superior tax efficiency:

It is ironic that it is mostly the same people that like to trade their funds around in the shortest period of time that also are most interested in aggressive tax planning strategies, because they hate paying tax.

The Australian capital gains tax system rewards long term investors, and penalises short term ones. If an investment asset such as a share, managed fund or real estate is held for less than one year, any capital gain is assessed at the investor’s highest marginal tax rate. Hold on for just over one year, and you get a 50% tax discount, so you only pay tax at half your highest marginal tax rate. At least some investors appreciate that, but they fail to appreciate that if you hold an even longer period of time you’ll get even better results.

If you can invest your money and achieve a 10% capital growth, but you sell every two years and incur capital gains tax, if your highest marginal tax rate is 48.5% you’ll end up turning $10,000 into $43,800 over 20 years, even with the 50% capital gains tax discount. If you could hold that asset for 20 years though, and not realise any capital gains tax until the end, you would get $53,400. This extra $10,000 comes to you because every time you realise a capital gain, you have to pay tax on it, and you send this money off to the tax office with your next tax bill. The longer you hold on to the asset, the longer you get to hold on to your capital gains tax liability and leave it in the market where it earns you money. It is like a long term interest free loan from the Australian Tax Office, and all you have to do in order to get this loan is extend your holding period.

For the record, a trader that achieves a 10% growth but realises the profit every year pays a much higher rate of tax and will end up after 20 years turning $10,000 into a mere $27,300. A short term trader would need to achieve a pre-tax profit of 17%pa in order to get the same profit as a long term investor getting 10%pa over 20 years. Now I can accept that through luck or skill some traders (a small minority) can beat the market, but achieving a return almost double that of investors and keeping this up for 20 years is a feat I’ve never heard of – and all that would give you is performance equalling that of a passive investor. In practice, the trader would need to do even better to make his or her efforts worthwhile.

It should be noted that index funds usually have a much lower turnover than active funds, which results in them making far fewer capital gains distributions. As there are less distributions, less capital gains tax is paid. Many active funds turn over 100% of their portfolio every year, which results in very poor tax efficiency.

Trading costs too much:

In several studies, Terry Odean and Brad Barber examined tens of thousands of accounts, incorporating millions of trades at two discount brokerages. Odean and Barber found a strong negative correlation between trader turnover and success. As you might expect these amateur traders performed significantly worse than the market on average. The 20% of traders with the highest turnover had the worst performance, while most traders underperformed the market by a few percent, the most active traders managed to underperform the market by a massive 7%pa (S&P500 index return over the period studied: 17%, most active traders: 10%).

Trading is expensive because there is much more to costs than just brokerage, which these days is less than $20 a time on the Internet. Odean and Barber found that brokerage was a minor expense, compared to the bid/ask spread.

When you want a quote for a stock on the market, there are really two numbers that apply. The bid is the price at which somebody wants to buy your stock. The ask is the price at which somebody else is offering to sell their stocks to you. On the largest and most liquid stocks this spread could be less than a percent, but on the really small stocks for which there is little trading activity the spread can be huge. As most of the traders in the study focused on smaller stocks and “value” stocks, they usually had to overcome a large spread.

This gap, easily a few percent in many stocks, needs to be crossed every time you want to exit a position. If the bid of a stock is $1.00, but the ask is $1.05, you’ll need a 5% capital gain before the bid gets to the price where you bought it. Multiply this by hundreds of times and you see the kind of appreciation that a day trader needs before he or she can break even.

Trading is significantly harder work than investment because long term investors don’t need to worry about the bid/ask spread as much, they only need to cross it once in many years, during which time the stock has presumably moved a great deal more than a few percent.

Combine the market costs of trading with the tax costs of trading and you can see it is a doubtful proposition: you need significant gains just to break even, but in order to make the same after tax profit as a long term investor you need very high trading profits on top of that. Factor in the argument from the previous article that you need to be way above average to beat an index after costs, and it is obvious that the number of profitable traders out there will be very small compared to profitable investors, and the latter don’t even have to work very hard.

Longer holding periods smooth out market cycles

The stock market is very volatile. That much is well known to practically anyone that has ever seen a stock price chart. There are lots of measures of risk, but the single number most usually called on to measure risk is the standard deviation of returns, a statistical measure indicating how widely returns are spread around their averages.

Double your time in the market, you can expect twice the return. Quadruple your time in the market, you can expect four times the return. But volatility doesn’t scale up in the same way. Volatility, on average, increases as the square root of time. If you double your holding period you’ll have twice the return, but fluctuations only sqrt(2)=1.4 times as great. Hold four times as long, you expect four times the profit, but the volatility of returns over this period would be sqrt(4)=2, twice as much. The longer you hold, the more favourable this risk/reward ratio becomes, volatility becomes virtually insignificant compared to capital gains over time, but you need to hold for many years.

In contrast, consider the trader. Traders need profits far above that of an investor to overcome tax and expense disadvantages, so the trader needs to take more risks. On a short time frame, the bid/ask spread becomes huge compared to potential profits, and brokerage is much more significant. The trader needs to adopt a very careful discipline of cutting losing trades short and holding winners as long as possible, to increase the relative size of winners compared to losers.

This is essential because costs always add to losses and subtract from profits, it is quite easy for traders to incur much larger losses than profits. Furthermore, even the most successful traders usually have a terrible win:loss ratio, they tend to close more trades at a loss than at a profit, which is why it is so important for them to make their winning trades really profitable.

How do you make your winning trades that profitable? Usually with substantial doses of leverage, and frantic trading on every move in order to compound their investment as fast as possible. Many traders make a living on the razor’s edge, dealing with a variety of derivatives and speculative stocks that have the potential to take the trader’s head off at any moment.

Traders can assess their performance with a formula called “Risk of Ruin” (a concept borrowed from gambler’s money management). The formula is more complicated than I’d like to get into right now, but it is a function of the ratio of profitable trades to unprofitable trades, the average loss vs average profit and the largest loss the investor is willing to withstand before calling it a day. The better these statistics are, the lower the risk of ruin calculated by the formula. Very few traders are able to maintain statistics good enough to produce a risk of ruin below 25%, which is considered the maximum acceptable number for prolonged speculative trading (and even then many say it is too high).

The ratio of winning trades to losing trades and average loss vs average profit is almost always excellent in long term buy and hold investors, over longer periods of time profitability becomes close to 100% certain in a diversified portfolio, and the potential for upside profit over a long period of time is significantly greater than the potential for loss. Risk of ruin, for long term diversified investors, is almost nothing.

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