I'm appalled at what I see individual investors doing these days on Wall Street. Buying and selling stocks by the day, the hour, even the minute.

Trading because it's as easy as punching a key on the computer and as cheap as a deli sandwich. Trading because they can, not because they should.

One of the things I find most offensive about daytrading — or weekly or monthly trading — is its arrogance. Daytrading implies that an investor has many, many, many good investment ideas. After all, if you're trading 50 or 100 or, in some trader's cases, a 1000 times in a single year, doesn't it imply that you feel each trade is a good idea, a potential winner?

Let's face it — most of us probably won't have 30 good ideas about anything in our lifetimes.

Warren Buffett, arguably the greatest investor of our time, owns fewer than two dozen stocks, many of which he has held for several years. If Warren Buffett has only a relatively few good ideas, why should any investor believe that he or she has 50 or more good investment ideas per year?

A famous college football coach once said, "When you throw a forward pass, three things can happen, and two of them are bad."

It's the same with selling investments. Selling an investment is the most dangerous part of the investment process. When you sell, a bunch of stuff can happen, and most of it is bad.

Taxes

By definition, traders rarely hold investments for 12 months or more. Unfortunately, constantly churning investments means paying taxes on gains at your full tax rate. If you're in the top tax bracket, you'll lose roughly 40 percent of your gains to Uncle Sam versus a maximum 20 percent if you hold the investment for 12 months or more. In other words, the tax penalty for trading stocks runs as high as 100 percent.

Taxes matter. What you pay Uncle Sam is money that will never earn you a dime in return.

It's gone forever. If you constantly buy and sell stocks, taxes will eat you up over time. Accounting for these trades at tax time will also eat you up. I guarantee you that many of these electronic daytraders got a real banjo lesson when they prepared their taxes. Uncle Sam requires you to account for every trade you make during the year. If you trade three or four times a day, think of the paperwork you generate come tax time. Think of the time spent tracking down the information for all those trades. Think of the dirty looks, not to mention hefty bill, your tax accountant gives you.

Bottom line: Trading equals taxes equals headaches. Big headaches. Of course, you can avoid these headaches by not selling your investments. That's what everyday millionaire investors do. That's what you should do.

Reinvestment Risk

As bad as they are, transaction fees and taxes may not even be the worst things that happen when you sell investments. The biggest downside of trading investments is "reinvestment risk."

When you sell any investment, you have to do something with the money. Reinvestment risk is the risk that what you do with the money makes you worse off than if you had done nothing at all. What happens when you sell investments?

		If you sell because you're concerned about the market, you might keep the money on the sidelines until you feel more comfortable investing. Selling and moving money to the sidelines takes your money out of play. The risk you run keeping money out of the market is that you are not maximizing the power of time in your investment program.
		If you sell because you think you've found a better investment, the risk you run is that the new investment may be worse than the one you sold. An academic study conducted a few years ago by Terrance Odean, a professor at the University of California at Davis, showed that individual investors, on average, buy stocks they should sell and sell stocks they should buy. One reason for this phenomenon is that investors (remember, investors are humans) hate to admit mistakes. So investors sell their winners and keep their losers. In the process, they sell stocks they probably should buy.
		If you sell to buy another stock, the risk you run is that the new stock is only as good or only slightly better than the one you sold. It's not enough that the stock you buy does as well as the one you sold or even a little bit better. It has to do a lot better. When you sell, you incur taxes and transaction fees. The new investment has to make up, at a minimum, the money lost to taxes and commissions. These costs provide a huge hurdle, especially if you generated big gains on the stock you sold. You're asking a lot from your new investment if it has to outperform your old investment by 20 percent or 30 percent just to compensate for taxes and transaction fees.

Trading Means No Home Runs

Smart investors swing for singles. The beauty of swinging for singles, as any major leaguer will tell you, is that you hit some home runs, too. If you trade stocks, however, you pretty well guarantee yourself of not hitting any home runs.

By definition, traders trade stocks. They don't hold them for many years. They dart in and out, taking a quick profit (hopefully) on each trade.

The problem with taking 25 percent or 50 percent or even 100 percent profits is that you will never — I repeat, never — own the stock that may rise to 500 percent or 5000 percent. And those are the stocks that give you a huge leg up in building a seven-figure portfolio.

You don't Reduce Risk by Market Timing — You Increase It

Why do investors sell? One reason is they think they can control risk by timing the market. The thinking goes like this — "If I can sell my investments at the top, I can avoid losing money."

In other words, trying to time the market is a risk-reduction strategy for many investors. The market seems high, so they better pull money out of the market.

Sounds good, right? Unfortunately, the reality is that you're never going to time successfully market tops and bottoms. You might get lucky a few times. But the one time you're wrong, you'll undo all the times you were right.

If you take nothing else away from this chapter, take this:

The biggest risk of investing is not being in the market when it goes down but being out of the market when it goes up.

Markets move in bursts. In 1998, for example, the Dow Jones Industrial Average moved from 7700 to 9400 — a 22 percent move — in less than two months. Many investors missed this move because they got out of the market when it dropped in August and September.

Don't worry about reducing risk by market timing. The proper way to reduce risk is by lengthening your holding period and diversifying across various types of stocks.

Besides, the payoff for perfect market timing, when you consider the risks, is rather skimpy. Let's say you invested $10,000 every year from 1988 to 1997 in the S&P 500 index. And let's assume you are the world's worst market timer. You invested that $10,000 every year at the exact market peak in the S&P 500.

At the end of 10 years, how much money would you have? Your $100,000 investment ($10,000 times 10 years) would have accumulated to a not-too-shabby value of $246,476. So even with lousy market timing, you more than doubled your money.

What would have been the payoff had you invested the $10,000 at the exact low every year for 10 years instead of the exact peak? Surprisingly, you would have added only $60,000 to your take, or an additional 24 percent.

Now $60,000 is not chump change. Still, when you consider the huge risks you incur to attempt perfect market timing for 10 years, and the even larger odds you face of being successful, a 24 percent payoff for your efforts seems hardly worth the risks.

And riding through a market downturn isn't the worse thing in the world. For starters, market declines provide opportunities to buy favored stocks at bargain prices. Secondly, history has shown that markets usually rebound reasonably quickly from major declines. During the 20th century, the stock market has risen in roughly three out of every four years. Furthermore, following every one of the major market declines in the last 40 years, the stock market regained its previous peak in an average 13 months and went on to new highs.

Of course, there have been times when markets declined and didn't recover for years. However, the percentages say that you probably won't have to wait more than a couple of years for markets to regain their lost ground. And if you buy during the down period, you amplify your gains when the markets recover.

The upshot of all this is that you can do just fine riding through market downturns and buying at market peaks. The trick is that you have to be committed to a long-term investment strategy. Conversely, you can get yourself into a world of trouble in the name of risk reduction by trying to time the markets.

When Should You Sell?

Does that mean you should never sell an investment? Legitimate reasons exist to sell an investment, but they are few and far between. The primary reason to sell is because the reasons you bought didn't materialize. Perhaps you bought a stock because of an exciting new product only to learn that other companies are coming to market faster with a better mousetrap. That's probably a reason to sell. Perhaps you bought a stock because it pays a hefty dividend only to have the company eliminate the dividend because of poor earnings. That's probably a reason to sell. Perhaps you bought a mutual fund because of the fund manager's strong track record only to see that fund manager jump ship to another fund family. That's probably a reason to sell.

Of course, in order to know when to sell, you have to know why you bought in the first place. I know this may be hard to believe, but it's true — most investors own a few stocks in which they have no idea why they own them. These may be stocks that are inherited or stocks that were given as gifts or stocks they acquired so long ago that they don't remember the reasons they bought.

Because it's so important to know why you bought a particular investment — especially when deciding whether to sell — I suggest you maintain a journal on your investments. Write down your reasons for buying an investment. Writing your reasons not only provides a record for future reference but also crystallizes your thinking on that particular investment. Indeed, you might find that, after writing down your reasons, your initial excitement for the investment idea wanes.

Another reason to sell is a rapidly rising debt level. A good way to monitor a company's debt level is to watch the ratio between a company's long-term debt and its total capital. (Total capital is long-term debt plus shareholder equity.) If this ratio is rising over time, examine the reasons. Is the company taking on debt to fund acquisitions or stock buybacks? Is the debt level rising at a time when profits are falling? High debt levels are manageable during strong economic periods. But companies that load up on debt during the good times may run into trouble during weak economic climates.

A third reason to sell is the "stupid" acquisition. Admittedly, I don't always follow my own advice here. I own several companies that have been big acquirers in recent years. Again, a strong stock market and healthy economic climates have helped limit the shocks that can come with making bad acquisitions. But know this — on average, mergers provide little, if any, lasting benefits for shareholders. And in many cases, acquisitions led to major problems.

If you own stock in a company that is buying another firm, try to put the deal in some sort of time context. In other words, companies that buy after takeover activity has heated up in a particular industry sector usually overpay for bad merchandise. The best fruit is picked early in the game. If your company is making a bold move in an industry that has not had much takeover activity, that's a proactive move that probably has been thought out thoroughly.If you own a company that is buying out of what appears to be desperation, that's probably a time to sell.

To Rebalance or not to Rebalance

A fourth reason to sell is because one of your winning investments now makes up a large part of your portfolio. This type of selling is called "portfolio rebalancing."

Let's say you bought Microsoft several years ago and held the stock through thick and thin. Chances are that Microsoft would now constitute a hefty part of your portfolio, perhaps as much as 30 percent or 40 percent of your portfolio if you had bought a lot of the stock. Many financial advisers believe no single investment should constitute more than 10 percent or 20 percent of your overall portfolio. The thinking is that you don't want the health of your portfolio riding on one or two stocks. To rebalance your portfolio means to sell a portion of your Microsoft and invest the money elsewhere. By selling, you reduce the overall weighting of Microsoft in your portfolio mix.

Obviously, selling to rebalance your portfolio is a risk-reduction strategy. Unfortunately, by definition rebalancing also means selling your winners. That's the problem I have with portfolio rebalancing. I hate to sell winners.

Yes, at some point the prudent thing to do is lower your exposure to an investment whose size overwhelms your other investments. But I believe your investment time horizon should dictate when you rebalance, not so much the weighting of the asset in your portfolio. For that reason, I wouldn't necessarily recommend to a 35-year-old investor that he or she should sell Microsoft because it represents 30 percent or 40 percent of his or her portfolio. That 35-year-old has a lot of investing ahead of him or her and can handle the risk should Microsoft go through a rough patch. On the other hand, a 60-year-old has to be a bit more defensive when it comes to holding a few investments that comprise the bulk of his or her portfolio. That 60-year-old doesn't have as much time to make up for a drop in those investments.

Personally, if I owned a stock that made up 40 percent of my portfolio, I would not be quick to sell the stock as long as I believed the stock's prospects were sound. I would not sell merely to rebalance my portfolio. When would I start to rebalance? That's a tough one and probably would depend, in part, on the nature of the stock. I would feel more comfortable having a big, time-tested, industry-leading blue chip, make up 40 percent of my portfolio than I would a stock in an extremely competitive, high-technology field making up 40 percent of my portfolio.

Most investment books provide black-and-white rules for rebalancing — "Rebalance if an asset grows to more than 10 percent of your portfolio," for example. You won't find such rules here. Every investor is different. Every stock is different. I do know that sticking to strict percentage allocations to run a portfolio will cause you to do frequent buying and selling of securities to keep those percentages in line. That's a mistake.

Buy with the Idea that You Cannot Sell

If you could never sell an investment once you bought it, you would make better buy decisions. That's how millionaire investors frame the investment process.

Buy investments as if you could never sell them.

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