by Archie M. Richards, Jr., CFP^®
March 18, 2002

Sell infrequently. Taxes and the costs of rapid trading will ruin your long-term results.

Mutt and Jeff illustrate the point. They each invest $10,000 into stocks, which gain 10 percent a year. For 25 years they make no withdrawals, except to pay 20-percent capital gains taxes on their profits from sales.

The costs of trading stem from several sources: Brokerage houses charge commissions. Market makers receive the difference between the bid and asked prices. And the Securities and Exchange Commission receives small fees on sales. We'll assume that these costs total 1 percent of the value of each purchase and each sale.

Jeff holds his initial stocks for the full 25 years, selling and paying tax only at the end.

Mutt trades much more often. Each year, he sells all of his stocks. He withdraws enough to pay the capital gains taxes and reinvests the balance into other stocks that also gain 10 percent a year.

The results? Jeff comes out way ahead. He ends up with $86,933. Mutt ends up with only $43,415.

They both have the same rate of return and the same costs. Mutt trades 25 times more often and ends up with less than half as much.

Here's why: The money Mutt pays out in taxes and trading costs all along the way doesn't continue compounding for his benefit.

Jeff keeps the money working for himself for as long as possible. Oh yes, he sells and pays the tax at the end. But he pays the tax later, which makes a big difference. He also pays only one set of trading costs, not 25.

Most investors trade stocks too frequently. A recent study of the trading behavior of thousands of investors revealed that, on average, stock prices rise more after people sell than they do before. The worst offenders are men, especially young, single men. They get those juices flowing and, man, they want action! But they should look for action other than in their stock investments. Rapid trading ruins results.

Other investors sell stocks to raise cash because they're pessimistic about the market as a whole. But time and time again, such feelings turn out to be wrong. The days when stocks move up the fastest often occur at the very times that investors are deeply concerned about the market going down.

One study tracked a hypothetical investment in the S&P 500 Index for the 10 years ending December 31, 1995. If you were out of the market on only the ten days during which the market rose the most, the return for the entire 2,529 days was reduced by half. In other words, being out for only 0.4 percent of the days produced returns 50 percent lower.

If you were out of the market on the forty days in which the market rose the most (1.6% of the market days), the result was a loss.

No one knows when the big up-days will occur. But if you miss them, you'll put your long-term performance way behind.

If you own individual stocks, buy at least 30 of them and sell sparingly. Most people are better off with mutual funds.

But before acquiring a mutual fund, check the latest year's turnover rate, usually shown at the bottom of the financial section of the prospectus. I prefer funds with a turnover rate of 10 percent or less, implying that the fund holds its stocks for at least 10 years on average.

Cut your taxes and trading costs. Sell as infrequently as possible.

Are you ready for good stock market news? For the eighth straight year, the 2002 Index of Economic Freedom shows improved economic freedom throughout the world. Countries are graded as to their low tariffs, low tax rates, minimal regulation, sound monetary policy, protection of property rights, minimal black market, and other indications of freedom from government control. (The U.S. ranks 4th.) Data from the past eight years can be found online at www.index.heritage.org.

Worldwide, 73 countries were given better scores than last year, 53 received worse scores, and 27 remained the same.

The greater the world's economic freedom, the greater the long-run returns of the world's stock markets. Freedom pays.