3 Ways Short-Term Investing Is Killing Your Returns

By Markets Fool.com

Here at The Motley Fool, we are all about long-term investing. We wholeheartedly believe investing for the long haul is one of the most certain ways to create wealth, and is the most effective strategy available to investors.

Continue Reading Below

On the other hand, short-term trading can be a portfolio killer. There are several reasons why such trading is rarely a good idea. Here are three big ones, courtesy of our experts:

Matt Frankel: One way short-term investing can kill your returns is the difference between the long-term and short-term capital gains taxes. Essentially, if you hold your stocks for less than a year, they can be subject to higher tax rates.

Long-term capital gains tax applies to investments held for more than a year, and the rates are pretty favorable. Most taxpayers (those within the 25% to 35% tax brackets) have a 15% long-term capital gains rate, and those in the lower two tax brackets actually pay no tax whatsoever on long-term capital gains. The only group that pays more than 15% is the top earners, those in the 39.6% tax bracket.

Tax bracket/Short-term rate Long-term capital gains rate
10% 0%
15% 0%
25% 15%
28% 15%
33% 15%
35% 15%
39.6% 20%

On the other hand, short-term capital gains are taxed at the same rate as your marginal income tax rate (your tax bracket). So if you are in the 28% tax bracket, you'll pay 28% of your profit on investments you sold before a year passed. If someone in that tax bracket holds their stocks for over a year, they'll only pay 15% of their profit to the tax man.

Continue Reading Below

In other words, if you earn a $10,000 profit on an investment, you'll walk away with $8,500 if you held the shares for more than a year and just $7,200 if the profit resulted from a short-term trade. As you might imagine, this can add up tremendously over the long run.

Dan Caplinger: Short-term investing comes with a huge number of costs, and even though one of those costs has come way down, it's nevertheless still a factor with certain types of investments and short-term strategies. Specifically, the transactional friction caused by buying and selling stocks is significantly more substantial than many people think, because there are multiple charges to consider.

Clearly, the key transactional cost is the commission, which is transparent and obvious when you buy or sell a stock. For the most part, commission costs have come down precipitously in the past few decades, with the rise of discount brokers making commissions an afterthought in many circumstances.

Yet commissions aren't the only costs involved in trading. Every time you place a buy or sell order on an exchange, you have to deal with market makers that are themselves trying to make a profit. The price that a market maker will offer someone trying to sell their shares will inevitably be less than what that same market maker will charge someone who wants to buy shares. That difference, known as the bid-ask spread, has also come way down over the years, with decimalization reducing the traditional eighth-point fractional spread to just pennies on the dollar. For less liquid stocks, though, the bid-ask spread can still be a huge deal, so it's essential to take it into account in assessing all of your transaction-related costs.

Jason Hall: As Motley Fool portfolio manager Jeff Fisher wrote recently, short-term trading is much more likely to be an underperforming strategy versus an approach focused on the long term.

The worst part? It's not just the lack of returns that hurts; it's the time you lose to grow your returns that you'll never get back. Here's how significant it can be:

Data source: Davis Advisors study. Image source: Jason Hall.

The table above is based on 20 years (1991-2010) of real-world data from a study conducted by Davis Advisors. The average fund returned 9.9% each year, while the average investor in these funds only gained 3.8% per year.

What explains the difference? If you'd invested $10,000 per year in the average fund and then left it alone, your returns would have been those in green. If you'd been the average fund investor, regularly moving your money in and out of funds, trying to actively manage your returns, your actual returns would be those in blue.

Even worse, you will never get back those 20 years to make up for lost returns.

If you're following a short-term trading strategy today, you're probably underperforming. If that's your situation, stop missing out on superior returns before you leave even more money on the table. Most importantly, stop wasting your most valuable asset: time.

The article 3 Ways Short-Term Investing Is Killing Your Returns originally appeared on Fool.com.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.