You May Have Heard That the Best Investors Are Dead Investors. The Study Behind This Statement Doesn’t Really Exist, but There’s a Reason People Keep Saying It.

If you search online for information on investing, you might find references to a report revealing that some of the best-performing brokerage accounts were inactive ones that had seen no trades either because the account holder had died or just forgotten about the account. 

While it turns out that this report doesn’t really exist — apparently just an idea that caught fire on the internet — the takeaway makes sense. Those who are not actively buying and selling stocks frequently are likely to do well, perhaps even outperforming their more active counterparts.

Image source: Getty Images.

In praise of inactivity

I’ve been aware of the power of infrequent trading for decades — initially thanks to a well-known report from the 1990s by researcher Terrance Odean, who analyzed the performance of many accounts from a discount brokerage and found that those that traded most frequently performed worse than those that traded least frequently.

“Not only do the investors pay transaction costs to switch securities, but the securities they buy underperform the ones they sell,” wrote Odean. These days, many excellent brokerages charge $0 for trades, but investors who actively buy and sell can still underperform their counterparts, in part because short-term capital gains face the investor’s ordinary income tax rate instead of the usually lower long-term capital gains tax rate, which is 15% for most investors.

Odean’s research also found women outperforming men — mainly because they traded 45% less frequently. Women have also been found to be less confident than men, in general, regarding investing, so they may approach it more cautiously and conservatively.

In 2000, Odean and Brad Barber, a fellow researcher, published a paper titled “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors.” In it, they noted that:

Individual investors who hold common stocks directly pay a tremendous performance penalty for active trading. Of 66,465 households with accounts at a large discount broker during 1991 to 1996, those that traded most earned an annual return of 11.4%, while the market returned 17.9%. The average household earned an annual return of 16.4%, tilted its common stock investment toward high-beta, small, value stocks, and turned over 75% of its portfolio annually. Overconfidence can explain high trading levels and the resulting poor performance of individual investors. Our central message is that trading is hazardous to your wealth.

That was written a quarter of a century ago, but is still good advice.

Day trading is especially dangerous

A particularly frequent kind of trading is day trading, and it, too, isn’t known for great results as day traders jump in and out of stocks quickly. The Securities and Exchange Commission (SEC) has warned that “day trading is extremely risky and can result in substantial financial losses in a very short period of time” and studies have backed that up.

Here’s another knock against active trading, from legendary investor Warren Buffett, who has said: “Calling someone who trades actively in the market an investor is like calling someone who repeatedly engages in one-night stands a romantic.” And: “If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes.“

High returns for the living

Fortunately, you don’t have to be dead to achieve great results investing in stocks. It would be good to aim to be fairly inactive, though. Buy into great stocks at good or great prices and then aim to hang on for many years, if not decades. That’s how my best investments have happened — I bought into good companies, and as long as they held my trust, I didn’t sell. It resulted in my portfolio growing like gangbusters.

But I could have saved myself a lot of trouble and gotten very good results just by opting for one or more solid low-fee index funds, such as the Vanguard S&P 500 ETF (NYSEMKT: VOO), which has averaged annual gains of 13.5% over the past 15 years. Note, though, that the S&P 500 has averaged annual returns close to 10% over long periods, and that means there were years when it went up and years when it went down. All investing involves risk.

Here’s how your money might grow over time at a more conservative (but also not guaranteed) 8%:

Source: Calculations by author.

See? That’s quite impressive — and it doesn’t require you to be dead, either! In fact, you’ll get the best results by being alive and adding to your portfolio every year. You might devote part of your portfolio to somewhat more aggressive index funds, as well.

So join me in chuckling at that apocryphal report, but take to heart its message that infrequent trading can outperform frequent trading. Being a sensible and diligent investor can lead to your becoming a millionaire.