I’ve always heard that it’s a good idea to buy and hold. I thought that this was a good idea because 1) long-term capital gains tax is much lower than short-term capital gains tax and 2) to avoid transaction fees from buying and selling stocks. There is a third more subtle reason that I’ll illustrate with a simple example.
Imagine I have $100 and I have access to two stocks, A and B, both of which grow 50% a year. Assume my capital gains tax is 20%. I’m investing over two years.
If I just buy stock A and hold it for two years my $100 turns into $100 * 1.5 ^ 2 = $225 I have to pay 20% capital gains tax on my gains of $125 of $25 and so I end up with $200.
Alternatively, here’s what happens if I buy stock A and hold it for a year, then sell it and use the money to purchase stock B: Stock A turns into $150 over the first year. Selling it requires paying 20% capital gains tax on the $50 I made so I now have $140. I use that money to buy stock B which grows to $210 over the course of the second year. I made $70 in that year which I have to pay $14 in capital gains tax on. I end up with $210 - $14 = $196.
Buying and holding for 2 years was the better option. This is because selling stock A after the first year triggered the capital gains tax which I had to pay at that point in time. In this case, I paid $10 after year 1 which I would have been able to invest to gain another $5 — of which I would have gotten $4 — which is the exact difference in outcome for both scenarios. One way to look at this is that by holding as opposed to selling I was able to get an interest free loan of $10 at the end of the first year where I had to put that $10 back into stock A. Instead of paying the government $10 now I’d rather be able to continue to invest it, benefit from the investment gains, and then pay that money back later.
Something that might be counterintuitive is that when it comes to roth IRA or traditional IRA, the order doesn’t matter in that all other things equal being taxed up front or at the end doesn’t matter. Mathematically, this is because order doesn’t matter in multiplication. Why then does selling a stock then buying another stock which sort of feels like it relates to order of events matter? This is because stocks, unlike IRAs, are subject to capital gains taxes. Mathematically, you can think about paying a capital gains tax as subtraction which followed by multiplation of future returns does make order matter. I’d rather hold onto my gains so they can continue to be multipled as opposed to having to pay them now. The expression is something like 100 * 1.5 - 10 vs. (100 - 10) * 1.5.