The Sunday Times 24 December 2017
The call to action in life is strong. Whether it’s the doctor that wants to prescribe, the goalkeeper that wants to dive or the investor that wants to trade; it is human nature to believe something must always be done despite evidence that in many cases inaction is better.
Anxious patients that demand a pill make it difficult for doctors to counsel inaction, but very often that is the wise course. And as a measure of the benefits to inaction it is a little disconcerting to note that the death rate falls when doctors go on strike, but it is nonetheless the case.
In soccer penalty kicks, goalkeepers almost always jump right or left but studies show the optimal strategy is to stay in the goal's centre. Because the norm is to jump, a goal scored yields worse feelings for the goalie that doesn’t do anything (stays in the centre) than for the keeper that jumps; leading to a bias for action.
And as far as financial markets go, much of the activity that continually happens is not serving a useful purpose.
Capitalism is about directing capital to its best and most profitable uses. Each year Wall Street directs about $250bn to Initial Public Offerings (IPOs) and secondary offerings. Yet activity on the stock market each year totals $33 trillion; so the vast bulk of activity is not related to the primary function of capital markets. According to John Bogle, founder of Vanguard, 99.2% of what Wall Street is doing must fall under the category of speculation, with the croupier at the table taking a constant rake.
As far as investors and trading is concerned, research from behavioural finance experts Brad Barber and Terrance Odean of more than 66,000 trading accounts found that the average investor turned over 75 percent of his/her portfolio each year. Transaction costs associated with this excessive trading reduced net performance by 3.7 percent compared with the market as a whole. Investors who traded most did even worse: these people turned over their portfolios more than twice each year, and as a result suffered a 10.3 percent reduction in net performance. The idlest investors enjoyed the best performance.
Odean also showed in 1998, that investors had a tendency to sell shares that had risen in value while holding on to losing investments, reducing returns further.
Dormant investors not only save on trading costs but also avoid ill-timed trades. A study, by Ilia Dichev, “The dark side of trading”, noted a distinct tendency for retail investors to pile in when everything is rosy and positive and to sell when it’s gloomy and bad. An unusual twist to the buy low, sell high advice parroted by the investment industry.
This unholy trinity of behaviour (trading too much, hanging on to losers and poor timing) translates in to mediocre returns for the investor. The typical investor doesn’t do nearly as well as the typical investment. All of this activity adds up to a lot more for the croupier at the table, and to a lot less for the client. I’m usually sparing in my use of gambling metaphors in investment articles but it has particular relevance here.
Explanations for what prompts us to want to trade are easy to find. As Financial Times columnist Tim Harford observes, we trade too often because we’re too confident in our ability to spot the next best thing. We buy at the top and sell at the bottom because we’re influenced by what others are doing. And we hold on to shares that have fallen in value because to sell them at a loss would be admitting defeat.
This may be why the world’s most successful investor, Warren Buffett refers to the appropriate level of activity with your portfolio as being benign neglect bordering on sloth. Impulse is your enemy.
And that impulse appears strongest amongst men. Much of the performance advantage that female investors enjoy over their male counterparts stems from their willingness to just do nothing. Another Barber and Odean study, “Boys will be Boys”, found men traded 45 per cent more often than women and earned 1 per cent less annually. Single men were especially guilty, trading 67 per cent more than single women and earning 1.4 per cent less annually. Both sexes are poor at picking stocks, the study found; but the difference in returns is almost entirely due to men’s aggressive trading.
Diagnosis may be easy. The cure is less so.
According to a Business Insider report there was a 2014 internal performance review of Fidelity accounts to determine which type of investors received the best returns between 2003 and 2013. The customer account audit revealed that the best investors were either dead or forgot they had accounts.
This says it all. There are not many walks of life where one can recommend laziness as a virtue. But for investors and goalkeepers alike, the advice is; don’t do something, just stand there.
Gary Connolly is Managing Director of iCubed, an investment consulting company providing investment support to financial advisors. He can be contacted at firstname.lastname@example.org or on twitter @gconno1. iCubed Training, Research and Consulting, trading as iCubed, is regulated by the Central Bank of Ireland.