Should I buy-and-hold or trade?
Your question pertains specifically to exchange-traded funds (ETFs); however, because the buy-and-hold versus trade decision is basically the same for individual stocks, I will answer within the general context of equity-style investing.
Investing vs. Trading
The primary difference between a buy-and-hold approach to investing and a trading strategy is one's time horizon. To some extent, the distinction is relative: a day-trader considers any holding period longer than a day or two to be investing, whereas a buy-and-hold investor might consider any portfolio with turnover exceeding just 10% or 20% per annum to be trading. For concreteness, however, let's define "investing" as holding any position for a year or longer, in line with the cut-off for tax purposes between long-term and short-term capital gains. Within this definition, managers running portfolios with turnover exceeding 100% per year will be deemed to be "trading."
Rationally speaking, the decision to invest or trade should be based on your assessment of two quantities:
Whenever expected pick-up exceeds frictional costs, it makes sense to trade out of one asset and into another that promises the higher return.
If markets are efficient, with perfect and instantaneous information flow among all participants, no pick-up in expected return should be available from switching out of one asset and into another; instead, frictional costs will only drag down returns. On the other hand, if it is possible to use available information to one's advantage to outsmart others, then trading can be a highly profitable business.
Prominent Winners and Losers
A glance at popular lists of the rich and famous shows that at least a few people have been amazingly successful trading the markets. Here are some well-known traders on the Forbes list of the 400 wealthiest Americans:
The persistent 15% t0 40% or higher annual returns these traders show is evidence that it is possible to realize consistent profits trading the market.
Lest we become too carried away with these success stories, we should also keep in mind that there have been many equally prominent "blow-ups" of risk-taking traders, including: Victor Niederhoffer, one of Soros's former colleagues, whose funds failed twice, in 1997 and again this year; John Meriwether's Long-Term Capital Management, the multi-billion dollar hedge fund run by ex-Salmon traders and even a couple of economics Nobel prize winners, which collapsed in 1997; and Amaranth Advisors, which spectacularly lost $6 billion in one week on natural gas futures in September 2006. This year's subprime crisis is another example of how businesses, investments and trading strategies that have been profitable for many years can suddenly turn sour. Then, too, think about all the unlucky traders who lose money so quickly that we never get a chance even to hear about them!
Base Strategy: Buy-and-Hold
The only certain way to know whether you yourself have the ability become a successful trader is to commit both significant time and capital to trying. Unfortunately, most people have neither the time nor capital to spend finding out. Also, for those who seriously begin trading but fail, the costs can be very high, both financailly and emotionally.
In my opinion, instead of launching off and haphazardly trying your luck at trading, it makes sense at least initially to pursue a buy-and-hold strategy to exploit certain advantages it offers:
1. Long-Term Returns Favor Equities: The nature of capitalism as we know it in the U.S. and in most parts of the world is that laws and regulations are skewed to promote economic growth, corporate profits, and wealth generation for stockholders. In this environment, risk-taking buy-and-hold equity holders more often than not end up with higher returns than bondholders and cash-rich non-risk-takers. Therefore, it makes sense to allocate as much of your portfolio as you can to equities, reserving for cash and bonds only what you need for emergency living expenses (e.g., six months' income in case you lose your job) or predictable future expenses (e.g., a college fund for children). While it is very difficult to predict whether equities will outperform bonds and cash in any given year, over periods of 10 or 20 years or longer, equities have generally outperformed.
2. Cost Efficiency: Compared to trading, buy-and-hold investing controls costs by keeping broker's commissions and other frictional costs to a minimum. Though not as evident as a trading commission, the bid-offer spread is a cost that can often be larger than commissions. To give an extreme example, a micro-cap "penny" stock with a $0.06-$0.08 bid-offer (you can buy at $0.08 and sell at $0.06 in an unchanged market) actually has round-trip execution costs of an enormous 25% of one's initial investment! At the other end of the spectrum are exchange-traded funds, the most liquid of which is the S&P Depositary Receipts (AMEX: SPY) with round-trip bid-offer costs of just 0.007% (or less than 1 b.p.). More typically, moderately liquid mid-cap individual stocks have bid-offer spreads of about 0.50% (50 b.p.).
3. Tax Efficiency: Keeping portfolio turnover to a minimum through buy-and-hold investing is also more efficient from a tax point of view. First of all, the long-term capital gains tax rate of 15% that applies to positions held for more than a year is substantially lower than the ordinary income tax rate running as high as 28% that applies to short-term capital gains on positions held for a year or less. For certain types of trading accounts, the IRS offers a favorable 60%/40% split between long-term and short-term capital gains tax treatment, which produces an effective tax rate of 20.2% (of course, higher than the 15% pure long-term gains rate). Also, since taxes on gains are due only when securities are eventually sold, capital gains tax can be deferred indefinitely into the future through extending buy-and-hold positions without selling for many years.
While it may seem simplistic, a buy-and-hold approach to investing, characterized by continuously holding a very high percentage of equities with only very infrequent though carefully considered buy-sell decisions, can, in my opinion, give small retail investors a slight "edge" over other investors and traders based on the efficiencies cited above.
To gauge the impact of frictional costs on returns, let's compare two portfolios over a 10-year period in a market that returns 10% annually:
Assuming that trading produces no pick-up in return, the frictional trading costs and additional tax lead to an inferior after-tax annual return 246 b.p. lower (8.94% vs. 6.48%) than the return available through buy-and-hold investing. On a pre-cost, pre-tax breakeven basis, the trading strategy will need to outperform the buy-and-hold alternative by a full 342 b.p. annually in order for trading to beat the buy-and-hold alternative.
As a rough rule of thumb, then, you should engage in trading only if you honestly believe that your buy-sell decisions give you at least a three or four percentage point advantage annually (and more if your turnover exceeds 200% per year) above the buy-and-hold alternative.
Self-Assessment: What's My Trading "Edge"?
Expressed another way, the buy-and-hold versus trading decision really boils down to having an "edge" large enough to overcome the costs of trading. What in particular about you, your personality, your abilities, and your current situation gives you a competitive advantage over others in the market? Based on the information you can easily get your hands on, digest and analyze, do you have an edge over professionals who devote themselves full-time and make careers out of trading the market?
While a genius-level of business and financial acumen may not be strictly necessary for wealth-building, I would contend that your odds of becoming a successful investor or trader will be greatly enhanced if you know what your edge is. If you plan to trade ETFs or large-cap stocks over a short-term time horizon, keep in mind that you'll be competing with Wall Street traders and hedge funds who usually have access to more up-to-the-minute newswires, customer flow information, and analytical tools than you do. Your odds of success may be slightly better in small-cap and penny stocks, asset classes that more sophisticated investors often avoid due to limited liquidity and trade size (Tim Sykes, whose claim to fame is trading his way from $12,415 to $1.65 million in just four years, day-trades small-cap stocks and is attempting to teach us all how it can be done again).
Over the years I have looked at many fundamental, technical and sentiment-based possibilities for constructing a system for beating the market, always searching for a methodology to ensure at least a 70% winning trade percentage. From one (perhaps too naive and hopeful?) point of view, given how readily availability price, volume, earnings and other quantifiable time series are, it seems that trading ought to be a "science" amenable to analysis and predictability. Unfortunately, from what I have seen so far, analytical trading rules do not appear to produce excess returns in any consistent and reliable way. Also, to date, I have yet to meet anyone who has a trading system that runs without human intervention and produces consistent excess returns. From what I can tell, trading is more like a game involving both luck and skill than a predictive science.
To Trade or Not To Trade?
Whether to engage in buy-and-hold investing or to pursue a short- or middle-term trading strategy, then, really depends on your own abilities and risk preferences. For the vast majority of people, I suspect that a buy-and-hold strategy will bear larger and more fruit than an active trading strategy. In my own case, I currently follow a buy-and-hold approach, targeting no more than 10% annual turnover to keep trading costs and taxes at a minimum.
Concurrently, I continue my search for a Holy Grail of sorts that is capable of producing winning trades at least 70% of the time (which I view as equivalent to a low-C grade, i.e., barely passing). The day I convince myself that I have a working system that meets this 70% threshold, I will begin to trade, putting real money at risk.
By the way, to anyone reading this: If you or someone you know has a trading system that produces consistent and reliable above-market returns, and don't mind sharing a little information about it, please leave a comment. We would all love to hear about it.