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Trading paradox – trading is bad for us, but we still do it Print

Mutual funds and ETF’s

Where the trading impact on gross returns is easiest to observe and measure is in mutual funds and exchange traded funds. A performance gap is observed between the returns of funds themselves and the returns of the investors in the funds. The gap is caused by investors selling in and out of funds, presumably based on their perceptions of where markets are headed. Because market timing is rarely regularly successful in the long term, the performance gap is a negative one:

·         John Bogle,former chairman of Vanguard, has estimated it for ETF trading at 200 basis points (2.00%) of lost returns each year and even higher for moving into and out of mutual funds; see Bogle 2011 doc.2231; and Canadian Capitalist 2011 Bogle Estimate PDF doc.2214.

·         According to a 2010 Cass business school study sponsored by Barclay’s Wealth the average annual return from UK equity funds was 6.5 per cent, but the average private investor made only 5.3 per cent, leading Barclays in 2011 to estimate that what it called emotional trading by wealthy investors had caused a 20% loss of returns over 10 years; see Clare Cass doc.2216 UK mutual fund trading; Barclays 2012 wealth trading study PDF doc.2210B; Sommer NYT 2011 Barclays Wealth 2011study of trading announcement PDF doc.2224; Vincent FT doc.2226; and Shah 2010 doc.2223.

·         Maymin and Fischer find that the average US mutual fund investor lags the average performance of his fund itself by an average of 1.95 percent per year over the past fifteen years, based on net investor cash flows of 25,000 mutual funds; see Maymin and Fischer doc.2219.

 If you don’t think the performance gap issue  is significant, consider this: a gap of 1.95%  left US mutual fund  investors with next to no return  after taxes and inflation over the last 15 years. Here is a pie chart from Maymin and Fischer’s paper showing this:

                                       

For more on this investor- fund performance gap, see Sullivan PDF doc.2228; and Individual stock picking by the individual investor: the pitfalls .

Other undesirable side-effects of trading

So, excess trading can result in significant additional turnover costs and tax costs, and hurt gross portfolio returns. But this is not the end of the story.

Excessive trading has additional results:

  • Simplicity is the friend of investors; for more, see How to invest simply- a 10 point checklist . Excessive trading complicates investing, making it more difficult to keep an overall view of one’s portfolio, often resulting in poor diversification. Simplicity is in fact the opposite of investing in shares of individual companies. You would need to invest in hundreds of different companies to ensure that your portfolio approaches being as diversified as an investment in a single index fund.  
  • It complicates tax and accounting.· 
  •  It is time-consuming. Each time you trade, someone as smart as you has taken a reverse position i.e. he thinks you are wrong. You have just created a full time job for yourself. Is that really what you wanted?
  •  It can lead to panic trading. Excessive trading often leads to your investments being too complex. You will have trouble understanding and managing the risks you are taking and you will likely wobble when markets get tough.·   
Do-it-yourself investing is not for everyone, but it can offer many advantages in terms of reduced costs and greater control over one’s financial affairs. Many investors retain an adviser because they find investing too complex and time consuming. Regrettably they often adopt trading patterns that worsen these challenges, and prevent them from being able to even consider do-it-yourself investing.

If your portfolio is not simple you may end up relying upon and paying others, even when that may not be your objective. Paying on a one-off basis for advice to develop your investment policy is money well spent. Paying others on an ongoing basis, simply because you have over time made a set of investments that have become so complicated you can’t manage them, is not. How to invest simply- a 10 point checklist .  

Conclusion

In the next commentary we look further at the trading paradox of why investors adopt a behavior that is contrary to their own interests, before outlining recommendations that may increase the likelihood of investors following better investing practices.



Last Updated ( Thursday, 10 January 2013 )
 
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