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Message subject : Avoid the trading trap

This message was posted by Walter on August 01, 2000 :

More evidence that buying and holding is the best strategy of all (for those of you who need reminding).

Is trading the surest route to success in the stock market? Judging by their actions, many investors apparently think that's a no-brainer. Spurred by the lure of low commissions online, the annual turnover rate of shares on the New York Stock Exchange and Nasdaq has more than doubled, from 59% in 1990 to 154% this year, according to the Bogle Financial Markets Research Center. It's almost as if we've seen the emergence of a new life form, the Robo-Trader, a mutant strain of investor who grazes on information from CNBC and regurgitates it in the form of online trades.

Stock trading has become such a national pastime that even usually docile 401(k) investors want to get in on the action. A survey of 250 companies with large 401(k) plans released this week by Morgan Stanley Dean Witter found that while just 8% gave employees the choice of buying and selling individual stocks two years ago, 14% offer this option today and another 9% plan to do so this year. "People want choice," says Morgan Stanley Dean Witter's Ruth Hughes-Guden.

I'm all for choice. But I also believe it's important that people understand the impact of the choices they make. And when it comes to trading, I think the evidence is pretty clear: The more you trade, the less you earn.

But don't just take my word for it. Read "Trading Is Hazardous To Your Wealth", a recently published paper by University of California-Davis finance professors Terrance Odean and Brad Barber. They examined the performance of the discount brokerage accounts of more than 60,000 households from February 1991 through December 1996, and separated investors into five groups ranging from those with the highest annual portfolio turnover to those with the lowest. (Turnover is a measure of how much of their portfolio's value investors replace each year; someone with annual turnover of 100%, for example, replaces the entire value of his portfolio every year.) In the 60,000-plus households Odean and Barber studied, annual turnover averaged 75%, while the most active traders had turnover of 258% and the least active just over 2%.

After reviewing returns of the five groups, the profs found that the investors with the highest levels of trading had the lowest returns. Specifically, the most active traders earned an annualized five percentage points less than the average household, and 7.1 percentage points less than the least active traders.

Already I can hear the fans of online trading out there grumbling, "Yeah, but those were discount-brokerage investors, not us Net investors who can execute trades in nanoseconds for less than $10."

Well, coincidentally enough, in another paper, "Online Investors: Do the Slow Die First," Odean and Barber looked specifically at people who had switched from phone-based to online trading between 1992 and 1995. For whatever reason--skill, luck, clean living--these investors had been unusually successful before going online, outperforming the market by more than two percentage points a year. After the switch, however, they increased their turnover by roughly 30%, and ended up trailing the market by more than three percentage points annually.

Not surprisingly, many investors have a hard time understanding why trading should hurt performance, especially with commissions as low as $5 a trade. The explanation is that the commission is only one of the transaction costs you incur when you trade. Another cost is the bid/ask spread, the markup you pay both when buying and selling that compensates a market maker for keeping stock on hand or acquiring it to sell to you. For large frequently traded stocks, that spread represents only a tiny percentage of the stock's price, say, 0.25%. But in smaller thinly traded stocks, that spread can represent 2% or more. In addition, the mere act of buying can sometimes drive up the price of a stock so that you pay more for several thousand shares than you would for several hundred. That difference is known as an "impact cost." Those costs add up.

Even if you're so good at stock picking that your gains far outpace the effect of these costs--a dubious assumption, but let's go with it--there's one more cost to contend with: taxes. "When you sell for a gain you instantly create a tax bill for yourself," says Robert Arnott, managing partner at asset management firm First Quadrant. "That can easily outweigh any skill you have." That is especially true if you're doing short-term trades, since gains on stocks held a year or less are taxed at ordinary income rates that run as high as 39.6% vs. capital gains rates, which max out at 20%.

Obviously, there are going to be times when trading makes sense. Maybe the prospects for a company change for the worse, or you want to capture a tax loss to apply to future gains. But the next time you feel the urge to act like a Robo-Trader, ask yourself: Whose bottom line is more likely to benefit, yours or your broker's? If you answer that question based on the available evidence, I think you'll find yourself doing fewer trades, and earning higher returns.

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