A good trading strategy is more than just how you time the stock market.
You’ve done the stock research, you’ve analyzed your personal risk tolerance, you’ve seen the position trends on SprinkleBit, and you’ve analyzed the company’s financials. You are now at the point where you already know what stocks you want to buy and you’re ready to jump in. But finding good investments is only part of the challenge. Even if you find a great investment, you still need to manage your trading strategy.
How often you trade has a tremendous effect on your investing results.
There are two basic types of trading strategies: buy and hold, and buy and sell.
The major difference between the two is a matter of market timing.
A buy and sell investor works hard to buy at the “bottoms” and sell at the “tops.”
A buy and hold investor simply doesn’t try. Personally, I prefer the buy and hold strategy.
This is partly because my experience has proved that it’s a better strategy, and partly because I’m naturally a lazy trader.
The lazy trader does not try to time the stock market.
The most common argument against a buy and sell strategy is the potential to miss out on huge market gains.
Since major fluctuations rely on market timing, but are randomly unpredictable, it is better to avoid trying to time the market. If you have the bad luck of making the wrong trades right before major market moves, then you could miss the entire year’s gains.
Accurate market timing is certainly an important factor, but many people ignore the argument. It’s easy to brush off the possibility of missed opportunities.
If you think you are good at predicting market changes, then it’s not something you need worry about.
I used to think that way before I invested in Ebay. In December 2008, I bought shares in Ebay at around $11/share. One year later, the price had doubled to $23/share. I decided to sell. My reason for selling had nothing to do with Ebay’s business. I thought Ebay’s business was great, but I was worried about a market crash. I tried to time the markets. The fact that I doubled my money made me feel like I was getting out on top. I was trying to time the trade so that I could reinvest at a better price.
My timing was wrong.
The crash I expected never came, and Ebay’s stock price continued to climb.
By the time I reinvested, the price had risen to over $30/share. It is now somewhere around $50/share.
It you find that hard to follow, here is a generalized explanation:
Based on the Ebay example, assume you put in $100 and took out $200. Then put that $200 back in. It would now be about $333.
But what happens if you put in $100 and don’t take it out? You would have close to $500. HUGE difference!
For me, that’s a good enough reason to avoid using a market timing strategy. But it might not be good enough for you.
The lazy trader has lower portfolio turnover rates.
There is a much more convincing argument for using a buy and hold strategy. It’s not based on investing skill. It’s based on math.
It’s a concept called portfolio turnover. Portfolio turnover measures how frequently your stocks are traded within a one year period.
This concept is mostly used to evaluate mutual funds, but the ideas behind it are also relevant for your personal portfolio.
It can be described in three different ways:
- If you hold investments for an average of one year, then your portfolio turnover rate is 100%.
- A portfolio turnover rate of 50% means that you replace half of your holdings each year.
- A portfolio turnover rate of 25% implies an average holding period of four years.
The direct connection here is that the higher your portfolio turnover rate is, the shorter your holding period will be, and the more frequently you are trading.
This is a useful measurement because each trade has commission expenses and market costs, and most trades have tax expenses. So the more often you trade, the higher these costs will be.
The lazy trader trades slowly, and usually reaps more returns in the long run.
Jumping in and out of investments will let these costs eat away at your returns. That is why, in my opinion, the best way to trade is to trade slowly.
In his book, Bogle on Mutual Funds, John Bogle estimates that every 100% of turnover reduces your returns by 1.2% each year. These are returns that you lose just by trading more often, and the disadvantage compounds over time. Over 40 years, a difference in return of just 2% will erase half of your gains!
So, by the numbers, you can increase your returns simply by trading less often!
How can you reduce your portfolio turnover rate?
There are a few ways you can help yourself reduce your portfolio turnover rate.
Warren Buffett’s solution to this problem is to imagine that you have a punch card with a limited number of lifetime trades. When your punch card is used up, then you can’t trade anymore.
Thinking about it this way will help you remind yourself that each investment is important.
Another way to force yourself to trade slower is by making your investment decisions on Friday afternoons after the market has closed. Then you will have an entire weekend to reconsider before your trades are executed.
On a longer time scale, you can reserve one or two months for making new investments and monitoring your current positions. For example, I only actively search for new investments during either December, January, or February.
It’s a lazy way of trading, but I find it more relaxing to focus on other things for the rest of the year than trying to time the stock market.