Your Biggest Edge in the Stock Market
August 10, 2018
The Biggest Investing Mistake
The faster you can go, the greater the risk. I learned this lesson the hard way, back in my days as a competitive cyclist. Do you want to know what skin looks like after sliding against the pavement at 30 miles per hour? It’s not pretty.
Today, online trading is teaching the same lesson to a generation of new investors: the Internet has us going fast enough to put ourselves in a lot of danger.
You can use your mobile phone to trade stocks from anywhere in the world. With my brokerage’s online app, I can check market updates while I’m working out at the gym. It’s quick and simple—and hazardous—because it allows for emotional decision making.
EdgePoint Wealth Management portfolio manager Andrew Pastor highlighted the scope of this problem. In a note to investors early this year, he pointed out that the average holding period for companies listed on the New York Stock Exchange in the 1960s totaled more than eight years. In the 2010s, that period has dropped to seven months. (Source: “Wait gain – 4th quarter, 2016,” EdgePoint Wealth Management, January 12, 2017.)
Average NYSE Holding Periods By Decade
|
Decade |
Average Holding Period |
|
1960s |
8.3 years |
|
1970s |
5.3 years |
|
1980s |
2.8 years |
|
1990s |
2.2 years |
|
2000s |
1.2 years |
|
2010s |
7.0 months |
(Source: Ibid.)
Pastor delivers a startling insight: holding stocks for as little as two to three years amounts to a competitive advantage nowadays. In the past, long-term thinking amounted to decades. Today, investors measure careers in months and quarters. As he puts it:
I believe the most overlooked edge an investor can have is time – the willingness to look further out than other people. Fortunately, those who want a time advantage don’t have to wait as long as they used to since investors are holding their stocks for shorter and shorter periods…Today, having a view about a business two or three years from now can be a proprietary insight.
Such frequent trading can extract an extraordinary toll on investor returns. In 2014, University of California professor Brad Barber conducted a study of 66,000 brokerage accounts. The study divided these investors into five groups based on the frequency of their trading activity.
As you would expect, the most active investors sabotaged their performance. The researchers found that the most active group underperformed their buy-and-hold counterparts by nearly seven percent per year (accounting for trading costs). (Source: “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” The Journal of Finance, last accessed August 10, 2018.)
The University of California study highlighted the explicit costs of frequent trading: brokerage commissions, bid/ask spreads, and margin interest expenses.
The biggest cost of frequent trading, however, doesn’t usually arrive until April of each year: a big tax bill. The IRS, probably in an effort to protect investors from themselves, doesn’t look kindly on high-flying day traders. Profitable stock flips (any round-trip investment in under six months) gets taxed at a premium rate.
But the real cost of frequent trading is far less explicit. In a world with Twitter, a 24-hour news cycle, and a way to trade literally at your fingertips, investors often let their emotions get the best of them. Time and time again, this results in making the exactly wrong decision at exactly the wrong moment.
To see how emotional investors get, investment strategist Gerard Minack studied the timing and volumes of mutual fund flows. As expected, he found that investors started buying stocks more aggressively at market peaks and pulled funds out of their investments near market lows.
Minack’s study found that a $100.00 investment in the S&P 500 at the start of 1997 (in other words, the “buy-and-hold” approach) would have grown to $150.00 by the end of the selected period. The dollar-weighted returns of mutual fund investors would have lost 75% over the same time frame. (Source: “Brilliant Morgan Stanley Strategist Retires And Reminds Everyone He Only Had A Job Because Investors Are Dumb,” Business Insider, May 17, 2013.)
The solution? Close the Twitter window, put away the smartphones, and for God’s sake, don’t turn on CNBC.
In the stock market, it pays to think like a business owner, not a trader. If you own a rental property, you don’t think about selling it every day so you could get into the electric car business. You’d think about how to attract better tenants, how to renovate the property to raise rents, or how to lower the cost of property maintenance. In other words, you plan to hold on to the business for the long haul.
This is exactly the type of operating philosophy we bring to every issue of my paid subscription service, Passive Monthly Income. The average holding period for all recommendations since the newsletter’s inception in 2015 is about two years. That’s how I approach every recommendation made in this publication. You’ll do yourself a big favor by doing the same.
