BULLS & BEARS: Trading too much in stocks a great way to erase profits

February 20, 2006

A common hindrance to creating wealth from stocks is overtrading.

Investors feel compelled to take a profit because, as they like to say, "If you don't sell, the gain is just 'on paper.'"

However, some of the world's best investors commit funds to a stock and hold it for fairly long periods; not forever, but quite a while.

According to the mutual-fund-ratingservice Morningstar, there is an inverse correlation between turnover and performance in the funds they monitor.

Sure, some folks are successful trading like mad, but most aren't.

Active trading is good for the brokerage firm and good for the IRS, but neither of those two is revered in the annals of history for their charity to investors.

There is an old saying: "Cut your losses and let your profits run."

Investors Business Daily is a popular newspaper among the stock-jockey crowd. On its Web site is a "learning center" for trading stocks. It lists its first rule of investing as: "Sell any stock that falls 8 percent below your purchase price."

Cutting losses closely is fine in theory, but I'm not sure it is the ticket to success.

Today, one of the more celebrated money managers is Bill Miller of Legg Mason.

His fund is the only one that has beaten the market 15 consecutive years. Over the nearly 24 years he has managed it, investors have earned a 16.5-percent average annual return.

Bill's fund has 41 stocks and his turnover is only 9 percent, which means he sold only four stocks last year. He obviously has conviction when he buys; instead of bailing at an 8-percent loss, he stays the course.

His biggest position in the fund is Sprint Nextel Corp. In the last year, this stock has suffered a 20-percent drop from its high, but he is still buying.

The current all-star wealth creator in stocks is Warren Buffett. Over the last 10 years, his company's stock, Berkshire Hathaway, has had an average drop from the previous year's high of 18 percent.

If he used an 8-percent stop, he would have been stopped out in eight out of the last 10 years.

In the past decade, Berkshire Hathaway stock has more than tripled in value.

If Warren were a firm believer in stoploss orders, he wouldn't be known as the "Oracle of Omaha."

No, instead of being fawned over like a rock star, jetting around to play bridge, and hanging out with Bill Gates, Buffett would be just another curmudgeon.

The giant General Electric Corp., which in essence represents the U.S. economy, has had an average year-overyear peak-to-valley drop of 26 percent a year the last 10 years.

GE's least volatile year was a 9.5-percent drop from 1998 to 1999. In GE's case, an 8-percent stop order would have snagged you every year and caused you to miss a 10-year double or triple.

If the world champs of investing don't use tight stop-loss orders, why should you?

Do your homework before you buy. If the company is sound, earnings growth is good, P/E is low, return on capital high, and prospects favorable, hang tough.

Forget about whether your profits are realized, or are just "on paper." If paper profits are good enough for Bill and Warren, they are good enough for me.

Gilreath is co-owner of Indianapolis-based Sheaff Brock Investment Advisors, money management firm. Views expressed are his own. He can be reached at 705-5700 or daveg@sheaffbrock.com.
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