The Right Way to Buy and Hold

Unless you're a pro, frequent trading won't work -- fees and taxes will eat your gains.
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Trading stocks to make money is a lot like building a great relationship with your mother-in-law.

In theory, it's a brilliant idea. In reality, it's almost impossible.

With the stock market down over the last three years, plenty of people have stepped up to dismiss -- even ridicule -- the concept of buy and hold. The problem is: Buy and sell and buy and sell and buy and sell typically doesn't work.

Looking back at the wild swings in the market, you might be tempted to start trading stocks frequently to profit from short-term fluctuations in price. Or maybe you've just given up on stocks altogether and moved your money to cash, thinking you'll hop back in when the market takes off for good.

Here's a list of reasons why those tempting ideas are nothing but terrible.

Study Those Studies

First, you can find numerous academic studies that show how investors aren't good at timing their stock selections or their moves in and out of the market.

In one study, Terrance Odean, an assistant professor at the Haas School of Business at the University of California at Berkeley, found that investors tend to hold losing investments too long and sell their winners too soon. Another research paper found that the households that traded the most had returns worse than average.

Richard Thaler, a behavioral finance professor at the University of Chicago, is preparing a study called

Investor Market Timing: Buy High, Sell Low

. According to his research, the percentage of new money invested in equities surged from 59% in 1994 to 74% in 2000 -- right as the stock bubble burst.

So much for correctly timing the market.

Performance Says It All

If you don't believe the research, then go to the numbers.

The vast majority of top-performing stock funds over the last 15 years are run by managers who don't trade a lot. That list includes names such as

(SEQUX) - Get Report


(DODGX) - Get Report

Dodge & Cox,

(LLPFX) - Get Report

Longleaf and

(CFIMX) - Get Report

Clipper. These stock pickers invest in solid companies selling at good prices, and they hang on.

Trading Will Cost Ya

In fact, investors who don't trade a lot also have an enormous performance advantage: They aren't blowing their gains on trading costs.

If you trade aggressively, then commissions and other transaction costs can eat up any profits you might make. And you'll pay taxes on any gains you realize. In fact, the tax code is stacked against people who don't hold on to their stocks for a year. Short-term gains are taxed like ordinary income. And long-term gains are taxed at just 20%.

Another problem with trading: Those price targets some investors come up with have no basis in reality. They're completely arbitrary. Just because

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stock once traded at $55 a share doesn't mean it will ever get back to that price. The same thinking applies on the downside as well. A number, by itself, doesn't mean a thing.

Not Enough Hours in the Day

Professional investors will tell you how tough it is to trade stocks. And they do it for a living. If you've got a job that doesn't involve sitting in front of a Bloomberg machine, then you aren't going to have enough time to trade during the day.

And after work, wouldn't you rather spend your free time with your spouse and family instead of doing research or staring at charts?

But the preceding screed isn't meant to suggest that you should build a portfolio of stocks or funds and then ignore it for 10 years -- or even 10 months.

You need to rebalance how much money you have in different stocks, sectors or asset classes at least once a year -- if not once a quarter. The exercise prevents the risk profile of your portfolio from changing dramatically.

This tactic also helps you sell high and buy low. You're systematically skimming the profits off the top of your portfolio and moving money out of areas that are probably more expensive.

Say you started 2002 with half a $10,000 in the

(VTSMX) - Get Report

Vanguard Total Stock Market fund and the other half in its

(VBMFX) - Get Report

Total Bond Market fund. By the end of the year, that portfolio would have had 42% in stocks and 58% in bonds. By rebalancing back to that 50/50 mix, you're keeping the portfolio from becoming a little too conservative. And you're taking some profits in bonds and putting some money into stocks, which look reasonably priced when compared with bonds right now.

Plus, this methodical strategy actually works. For most people, trading does not.