Tuesday, August 28, 2012

Trading Frequency: Can Less Be More?

When I explain Net Worth Advisory Group’s “Best Stock, Best Funds” investment strategy, people sometimes question why we only update our portfolio holdings once a year.   Some people wonder if I am earning my management fee if I don’t make changes more frequently. In reality, study after study concludes that when it comes to portfolio turnover, less is likely more.

Who is the most successful long-term investor in the United States?  This would be a person who has made billions of dollars by purchasing stocks; not by building businesses directly such as Bill Gates did with Microsoft.  The answer is very obvious:  Warren Buffet.  A $10,000 investment in Berkshire Hathaway in 1967 would be worth $50 million today.

The next question is:  “How often has Warren Buffet, on average, held the stocks he has purchased?”  We don’t have an exact number, but the answer would be for many, many years. In fact, Warren Buffet hardly ever sells any stock he purchases. This example, although atypical, supports the premise that an investor doesn’t have to trade stocks frequently to be successful.

Many studies show that frequent trading actually has a negative impact on investment returns.

A Dalbar study[i] shows that individual investors achieved an annual average growth rate of 3.83% from 1991 through 2010. However, the Standard & Poor’s 500 Index had an average annual gain of 9.14% during that same period of time.  Analysts believe the reason for the significant difference is that investors, especially at extreme points in the stock market, tend to buy high and sell low.

Even professional investment managers often trade excessively. William Harding, an analyst with Morningstar, says the average turnover ratio for managed domestic stock funds is 130 percent.[ii]  That means every security held in the portfolio is replaced 1.3 times during the year.  By comparison, during the last 10 years, 15 of the top 25 large cap blend funds replaced less than 30% of their portfolio each year (approximately the same turnover rate as Net Worth Advisory Group’s “Best Stocks, Best Funds” strategy).

With most mutual funds trading so frequently, it’s no wonder that the average transaction cost of these investments is 1.44% per year.[iii]  Note that the transaction costs of mutual funds are not easily obtained; they are not published by mutual fund companies.  Also, be aware that a mutual fund’s turnover expense is in addition to its expense ratio (which for the average US stock fund equals approximately 1.1%).  Consequently, when combining these two fees, the average mutual fund charges its investors over 2.5% per year.

Mark Hulbert wrote an article that appeared in the May 2011 AAII Journal titled “Think Twice, Even Thrice, Before Trading.”  For those who may not recognize his name, Mr. Hulbert is the editor of the Hulbert Financial Digest, a newsletter that has ranked the performance of investment advisory newsletters since the early 1980s.

Over the years Mark has tracked thousands of model portfolios.  He recently created a hypothetical portfolio for each newsletter that froze the portfolio holdings at the first of the year instead of selling any of them.  His research revealed that, in 2010, the 500 model portfolios tracked would, on average, have made 18% if they had simply stuck with their holdings at the beginning of the year.  Their actual portfolios gained 14.6% for the year. Overall, since his newsletter began thirty years ago, two-thirds of the portfolios would have done better by not trading.  Also, there was no calendar year when the majority of portfolios came out ahead of its frozen counterpart.

An article appeared in the July issue of the AAII Journal that supports Mark Hulbert’s findings.  It was entitled, “Behavioral Errors Hurt Your Returns,” and contained an interview with Daniel Kahneman, a Noble Prize laureate and Princeton University faculty member. Dr. Kahneman cites a study done by an associate where he examined the decisions of individual investors who sell a stock and buy a replacement stock merely because the investor believes the stock he sells is inferior to the stock he wants to buy. On average, if you look at the value of the stock that was sold a year later, you find that the investor could have made 3.5% more by having held onto what he considered to be an inferior stock.  It is also interesting to find that women are better investors than men because they turnover investments less frequently.

Dr. Kahneman concludes: “The real enemies of good returns are churning and lack of diversification.  Individual investors fall for both of those.  So that would be my advice:  Avoid churning and avoid making decisions (to sell) because individual investors are really, by and large, not equipped to make the decisions.”

It is a human tendency to want to “do something,” especially at times of extreme optimism or pessimism in the market.  Our culture programs us to think that making more decisions will add value to our lives. To become better investors, we need to learn that sometimes the best action is to not take any action at all.  We should consider the quality, not just the quantity of decisions we make. The above examples show that there is a negative correlation between trading activity and investment returns.  Sometimes less is more.

[i] “Quantitative Analysis of Investor Behavior (QUIB),” Dalbar, www.dalbar.com.
[ii] “How Does Turnover Ratio Affect My Mutual Fund Return?” March 30, 2011, www.polarisfinancialplanning.com.
[iii] “Hidden Cost of Mutual Funds,” Anna Prior, Wall Street Journal, March 1, 2010.

1 comment:

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