Many investors claim you should buy and hold investments, ignoring short-term market dips. However, some stocks decline to zero, and buy-and-hold investors regret skipping selling opportunities that would have preserved cash. Short-term investors hold investments for one to three years and ride short currents in the marketplace. This approach results in some exciting gains when you are right, but can deplete your portfolio if you’re wrong. Examine the pros and cons of each approach.
High Short-Term Gains
If a stock has sudden gains, you must make an estimate of its ability to sustain those gains. For example, if you hold a stock that shoots up 20 percent, look ahead and ask yourself whether market volatility will bring it back down. The markets seldom average a 20 percent gain in a year, so you are already ahead in this example. You can lock in a gain now and repurchase the stock if it drops to a cheaper price. This kind of short-term analysis can be wrong, however, because some stocks simply take off and never look back. You have to be willing to miss out on future gains in order to lock in short-term profits.
Moderate Long-Term Gains
Stocks that tend to grow slowly qualify as long-term possibilities for a portfolio. These stocks tend to be less volatile because the underlying company has steady but not spectacular growth. The gains take a long time for you to realize, but you experience less risk. This approach will not produce current income, but it may build your retirement funds steadily.
A Hybrid Approach
You can mix short-term and long-term investments in your portfolio. Many investors do this by allocating a percentage of cash that shouldn't be placed at high risk. The part of a portfolio they want to protect can go into long-term investments that appear to be lower-risk investments. While you never have a guarantee that you won’t lose money, a long-term investment in a steady company’s stocks may have a greater chance of moderate growth with moderate risk. The riskier part of a portfolio can work in short-term investments. This method allows for greater potential for gains, but if you choose this method, you must tolerate increased risk on your short-term investments.
Any investment you hold for longer than a year qualifies for capital gains tax when you sell it. This tax is usually lower than your ordinary income tax rate. Investments you hold for a year or less get taxed at the same rate as your ordinary income. This rate tends to be higher than the capital gains rate. Wise investors do not make buying and selling decisions based solely on how gains will be taxed. The tax savings you receive by holding a stock longer than a year seldom offset the losses that a volatile stock can experience. In other words, if you think a stock may go down, holding it just to avoid short-term tax rates is not a profitable strategy.
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.