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How To Employ A Balanced Investment Approach.

This guest post is brought to you by The Digerati Life.

When we hear of the terms “Short Term” and “Long Term” in the investing world, these terms refer to an investment period. Traditionally for tax purposes, the Short Term is defined as any investment holding time period less than one year while Long Term is any time period greater than one year. One technical difference between the two is how you record your Capital Gains and Losses on the IRS Schedule D. It has been suggested that small investors should not invest in the short term due to high commission charges. But with the advent of online stock trading, and lowered commissions offered by many discount brokers, that advice has less relevance.

For small investors, investment experts have long advocated the principles of long term investing. “Buy and hold for the long term” is considered one of the main stock market investing strategies around. On the other hand, in recent times, more online trading platforms have been developed which allow for less expensive commissions. This certainly encourages the growth of short term investing. Lower commission rates have become more standard among the best online brokerages around. This may very well encourage a lot more short term investing among investors — with many opting to become more active with their trading. But I believe in more of a balance when it comes to managing one’s investment activities: small investors should mix Short Term investing with their Buy and Hold investments in order to make significant enough gains to keep up with inflation, which has long term effects on your investments.

When To Use A Short Term vs Long Term Investing Approach

Let’s say you bought ten stocks a few months ago, and a couple of them are performing poorly. Should you simply hold on to those bad stocks and wait a year? It could be years until those stocks turn upward. Or consider the opportunity costs of your losses by using the Buy and Hold strategy. If you sold the losing stocks in your portfolio after six months, and used the money to buy the winning stocks you researched in the meantime, wouldn’t that be better than holding onto a loser simply for the sake of following a buy and hold strategy or being overly worried about taxes? You have to cut your losses at some point and you may wait longer than a year, but this is something you don’t have to do anymore. Perhaps buying and holding most of your investments and mixing that with some short term trades (done purely strategically) may help you better optimize your investment strategy. A lot of investors cut their losses in the short term in order to tweak their portfolios. In many instances, this makes sense — say when you harvest tax losses or when you do portfolio rebalancing.

The risk in Short Term trading in the past was taken by those people who had large amounts of money at stake for a few minutes, while they profited from a minuscule up tick in the security’s price. Investing like that is not investing. This tactic uses the investment system as a casino and really only belongs to the world of professional traders. The common wisdom here is to keep your trading to a minimum — involve 5% or less of your portfolio in such endeavors. Most of your portfolio should be in mutual funds and index funds where you employ Long Term Investing strategies such as diversification and some degree of buy and hold. But in certain situations, doing a short term trade shouldn’t be a problem if you keep such trades down to a manageable level.

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Comments (5)

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  1. Edwin says:

    The trick to breaking from a buy and hold strategy is 1) having the knowledge of when to trade and 2) going against emotion and common wisdom.

    Both are very difficult as 1 requires you to understand the economy and the specific industry enough to see for example if a bubble is occurring (like if someone had been tracking the price:rent ratio during our housing bubble).

    The second is arguably even more difficult. Using the housing bubble example, even if you were tracking price:rent and other indicators, the talking heads in the news and places like CNBC told you that prices are going up forever and we are in a new paradigm. It can be difficult to not just listen to what is hyping the bubble and go along with it even if you may know otherwise.

  2. I recently read a great book on the topic. Its called The Naked Portfolio Manager by Robert Fischer.

    It basically gives you a guide about how to take all emotion out of building your portfolio.

    It really changed my invesment approach.

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