To have a pre-disposition to buy and hold stocks for the long-term can be an extremely expensive frame of mind. The long-term market trend is up, but in a volatile stock market, the long-term gain is often laden with risk and not nearly as great as many short-term gains. Risk vs. return has greatly increased for the long-term stock market investor. People argue that tax consequences are their reason for holding. That argument lacks weight. It is very difficult for some people to break away from old habits and patterns of thinking about the stock market. Those who are unwilling to learn from market crashes are doomed to repeat the lesson.

A few years ago, investors were told that to buy and hold for the long-term was the wise course of action for investors because the long-term trend of the market is up. If you took any other approach, you were a speculator at best and a gambler at worst. Brokers and mutual fund managers were the most vocal proponents of this investment philosophy. The media also joined the chorus and the concept became a part of the "accepted" market lore. Investor thinking, in this regard, lost elasticity. What was overlooked was that selling a stock that has entered a phase of heightened risk actually reduces portfolio risk, whether it has been held a year or not. It is important for us to have clarity about the main issues relating to the length of an investor's holding period.

The new volatility of the market is probably here to stay. The current reality of the market is that in a given year stocks will often undergo multiple price swings in which the magnitude of those short-term swings is often equal to or greater than the magnitude of its 1-year price movement. Even stocks that lose money if held for a year may be very profitable at several times during the year. Unless the long-term expected gain is much greater than the average return on stock investments, it is a high-risk gamble to retain a stock that has moved up 20% in only 2 months once its charted growth rate has started to show signs of breaking down. The probability is that holding on to such a stock to meet a 1-year long-term tax requirement will cost way too much. When stocks move up rapidly, it is common for them to vigorously and abruptly "correct" to the downside once they begin to break down. It's like a crowded auditorium in which someone yells, "fire!" Everyone wants out at once. Potential buyers then become like those outside the auditorium waiting to get in. When they see all the people rushing out in a panic, they naturally decide to wait and watch rather than entering. Thus, while the potential buyers wait, the stock plummets.

The potential reduction in the investor's tax rate resulting from a long-term holding period is not sufficient to make up for the substantial risk of loss. If you have a 20% gain, why not take it rather than lose it? Selling in less than a year is fairly easy to justify under these conditions. Though the figures can vary depending on how you file, even at the highest tax rate it would still make more sense to sell under such circumstances (tax rates may be somewhat different when you read this but the point remains the same). For example, even if your income were $500,000 a year and you had no deductions, 3 short-term gains of $18,000 or 2 of $27,000 would net you more after taxes than one long-term gain of $40,000 taxed at 15%, regardless of how you file. That is, taking several small short-term gains in a choppy market can be more profitable than hanging on to a stock in the hope of obtaining a larger long-term gain. Furthermore, in an environment where the long-term gain is unlikely to be obtained (and where the gains already achieved are likely to be siphoned off by the market), it makes even more sense to lock in the profits already obtained once a stock begins to break down.

Stocks do not move in a linear fashion. Stockdisciplines.com traders have found that if a stock is up 20% in 5 months, it is unlikely to be up 40% in 10 months. It is more likely to be up 8% in 10 months or even down 10%. Hence, the key to higher net returns is to base investment decisions not on the nature of our tax code but on the proper weighing of risk against reward. If all things were equal, it would generally be better to hold for the longer term. This is obvious, and it is our own preference. However, all things are rarely equal and stock patterns do break down. When a stock begins to drop, the preservation of capital is much more important than getting a lower tax rate. Those who invest by the tax code rather than by the signals given by the stocks themselves often end up paying less in taxes because they don’t make any money. They get the deductions they long for (a lot of losing positions) but not the profits. The priority should be to make money in the first place and after that to have your CPA help you keep it from being taxed away.

The fact is that no one can say for sure that none of the stocks in a given portfolio will plummet out of existence (even if they are all blue chips). Of course we would all like to buy nothing but steady climbers and leave them in the portfolio for a year or more to get the long-term capital gain tax benefit. Five years would be even better because it would reduce transaction costs. However, the market and your stocks do not care about your wants, needs, or tax status. Also, transaction costs can be minimal. At one well-known discount brokerage firm, for example, it is possible to sell out a position worth $50,000 for only $7. If the stock price is $40 a share, the brokerage commission for this trade would come to little more than half a penny per share. This cost is insignificant relative to the loss that could be incurred by keeping a loser.

If we buy a stock and it starts to break down shortly after we purchase it, we must admit that either we were wrong or that the unforeseen has occurred. Certain conditions and requirements had to be met by the stock and/or the company for us to buy it in the first place. If those conditions no longer exist, we must sell. Our prime consideration in a volatile environment must be to preserve assets, even if we have to sell a stock the day after we bought it. On the other hand, if we achieve a return of 20% in 6 months and the stock is still strong and still close to support, we will continue to hold because we have not been given a reason to sell. The same would be true if we had held the stock for 5 years and our gain were much greater. The stock itself, or the market, will tell us when we must sell. Volatility-adjusted stop losses are extremely useful in this regard.

There is no way to know in advance how long a given stock should be held. We should not invest on the basis of what we think ought to be but on the basis of what is. Though a 1-year minimum holding period is desirable for tax considerations, it is meaningless and arbitrary in the context of market behavior. In fact, rigidity in our thinking along these lines can be very costly. Of course we want to hold a stock as long as we can, but rate of growth and risk should not be ignored. A stock that has proven itself incapable of breaking through overhead resistance no longer has growth potential, and continuing to hold it involves risk of loss (the risk/reward ratio has changed). In fact, risk of loss will increase as others conclude the stock will not go higher.

It is difficult to leave behind old concepts of investing. It is one thing to be aware that a particular stock has given a sell signal and another to break loose from old ways of thinking in order to act on that signal. This is something that takes time to internalize to the point where it is automatic. A good, well-articulated discipline can be an effective trainer in this regard. There are, after all, lessons to be learned from every plummeting stock and every market crash. Investors must learn to allow stocks and the market to give their own signals. When those signals are given...we must learn to listen.

Copyright 2009, by Stock Disciplines, LLC. a.k.a. StockDisciplines.com