Trading Is Hazardous to Your Wealth

An important aspect of investing in the stock market is how often you trade, which can be viewed on a continuum. At the high end of the continuum are day traders, who make several trades each day, rarely holding a position for more than a few minutes or hours. A bit further down are swing traders, who might hold a position for a few days or weeks. At the low end of the continuum are buy-and-monitor investors (which I think is a more appropriate label than "buy-and-hold"), who hold their positions for years or even decades as long as the fundamentals remain sound. Thus, when framed in terms of portfolio turnover, day/swing traders have very high turnover rates, whereas buy-and-monitor investors have very low turnover rates.

What is the effect of turnover on returns for individual investors? I recently came across a study that provides some relevant data. Barber and Odean (2000) looked at the relationship between common stock investment performance for individuals (not mutual fund managers or institutional investors) and the rate of portfolio turnover for a period from 1991-1996, in the midst of a bull market. During that time, the market returned an average of 17.9% per year. How did individual investors do?

Investors were divided into quintiles based on how often they traded. Interestingly, all groups had gross returns (before trading costs) that were very similar to each other and to the market. However, the groups differed in their net returns (after trading costs): The group that traded the least had a net return of 18.5%, which was almost equal to its gross return and slightly better than the market. The group that traded the most had a net return of 11.4%, despite having a gross return that was essentially identical to that of groups that traded less often, which means that a large chunk of their return was lost due to trading costs. Overall, the more that a group traded, the lower its net return. On average, individuals turned over about 75% of their portfolios annually.

These results and related findings show that frequent trading is detrimental to investing performance (in terms of net return). Barber and Odean (2000) suggested that one reason for this relationship is that some people become overconfident and overestimate the value of the news and information they learn about their stocks. This overconfidence compels them to act on their information, leading them to trade more often.

Based on such research, one of the principles of my investing strategy is to keep portfolio turnover at an absolute minimum. Last year I had some turnover because it was not until later in the year that I finally settled on the dividend-growth investing strategy that I now follow. Thus far this year I have had 0% turnover -- I have not sold a single stock (see my Transactions page). To minimize turnover, I adhere to a set of criteria associated with selling stocks that I plan to write about in the future. In addition, I completely refrain from day and swing trading, and I do not follow any sort of market-timing strategy. I think my approach is sensible and will ultimately result in investment performance that is in line with my goals.

Reference: Barber, B. M., & Odean, T. (2000). Trading is hazardous to your wealth: The common stock investment performance of individual investors. Journal of Finance, 55, 773-806. The article is available from Barber's website.