Investing is putting money into something with the expectation of gain, usually over a long term. Trading is putting your money into something, but with the intention of quickly thereafter pulling your money out, then quickly repeating the process over successive new cycles of putting in/pulling out. Sounds obvious: investors do the former, traders the latter. Yet countless investors trade their portfolios to such an extent they come to resemble traders. In this commentary we explain why trading is hazardous to your financial health and hope to convince you to change your habits. In a subsequent commentary we explain what drives investors into trading, and what can be done by investors themselves and by regulators to cure investors of an expensive habit

Introduction

Passive investors typically trade for two or three reasons, to accommodate cash flows, to maintain target risk-return tradeoffs i.e. Asset Allocation rebalancing, and occasionally for tax-loss harvesting (more below on loss harvesting). Any other trading is a symptom of active investing, and results in what we call excess trading; see Avoid short-termism: rules of thumb to borrow, trade or stay in cash for some other good reasons.  .

Active investing, of which excessive trading is but one example, has a major cost on investors, on financial markets and on the economy; Kenneth R. French in 2008, estimated the aggregate cost of active investing as follows:

• The cost of active investing in US equities is 0.67% If the expected real return on U.S. equity is roughly 6.7% and we assume the annual dollar cost of active investing will not increase in the future, society’s capitalized cost of price discovery is about 10% of the current value of the market. Ken French Presidential address- The cost of active investing , The Journal of Finance 63, 1537-1573, PDF doc.1993.

Investors who trade to such an extent they come to resemble traders can be small, retail investors often at discount brokers or wealthy individual investors often at full service brokers. But don’t feel badly, even mutual funds and other institutional investors over-trade; on institutional overtrading, see Zweig Institutions trade too much - PDF doc.2227.

The impact to investors of excessive trading are of two types: the higher turnover costs incurred by actively-traded portfolios, clearly a negative; and the impact on the gross financial returns of actively-traded portfolios compared to less traded portfolios, a more difficult factor to quantify.

Professional traders

Of course there are also day traders and other professional traders but they make no pretense at being investors at all. Professional trading is an occupation with its own rules and pitfalls that if not followed, will cause grief to the traders; see RatioTrading . Ironically, trading too much can even play havoc with professional traders; see Burns 2007 traders over-trade PDFdoc.2213.

One of our favorite traders is Charles E. Kirk. We encourage you to visit his web site TheKirkReport and read his free reports on what is required to be a successful trader. You will quickly realize that few of us have the necessary skills. When amateur traders transact, professionals like Charles Kirk are often taking contrary positions. Who do you think comes out on top?

Transaction (turnover) costs

As a general rule, irrespective of whether an investor realizes trading gains or losses, he will incur transaction costs, what we call turnover-related costs. The greater an investor turns-over his portfolio by selling and buying, the greater his transaction costs.

Commissions

Commissions are the charges a broker collects to purchase or sell a security as agent for the investor. They are typically lower at discount brokers (versus full service firms) and lower in percentage terms the larger the dollar amount of a transaction. The commission for a share trade is shown on the confirmation slip.

While equity commissions have come down in Canada with the increasing popularity of discount brokers, the overall volume of equity trading in Canada over the last 10 years has increased about 500%; see Mathisson Credit Suisse 2011 doc.2218, slide 26. In the US volumes have gone from a 15% annual turnover to 25)5 in 2011; Geer Bogle interview doc.2217.

Typically, investors are offered bonds from a broker’s own bond inventory and transaction costs are built into the bond price. Clients often don’t know whether a bond is priced competitively or how much commission they are paying, and for small amounts (eg. Less than $10K commissions are so high GIC’s or bond funds may be more attractive. For more, see Conventional bonds on the Canadian financial wiki Finiki, and Bebee GandM 2012 Bond trading doc.2212.

Options are subject to higher commissions than equities. Like shares, the commission for an option trade is shown on the confirmation slip.

Spread and market impact trading costs are above and beyond commission costs.