A few years ago, I read about a study conducted by Fidelity on its client brokerage accounts. The study tried to identify the best performing investors at the brokerage, by reviewing account returns.
They came to a stark discovery – the best investors were either dead or had forgotten to log on to their accounts for a long period of time. Perhaps they forgot their passwords, and got locked out of their accounts, but didn’t bother resetting them.
It makes intuitive sense that accounts where investors do little trading would do better than accounts that are more active.
There are several reasons why that would make sense:
1) When you buy and sell stocks often, you incur costs.
Back in the day, you had to pay a commission to buy and to sell a stock. If you do that enough times, you can be out of some serious cash. Even if you lose 1% of your portfolio value to commissions and fees each year, that could eat away a sizeable chunk of returns over time. Costs compound over time, but unfortunately not in your favor. Plus, when you buy and sell stock, you end up losing a little bit on the buying and selling, because you buy at the ask price and sell at the bid price. The difference varies from company to company, but it also adds up over time. We are not even going to discuss taxes, which can eat up a portion of returns, especially if you invest in a taxable account.
2) When you buy and sell stocks too, you often pay an opportunity cost as well.
I have read some academic research that showed how companies that investors have sold tended to do much better than the companies the investor replaced them with. For example, if you sold Johnson & Johnson (JNJ) in the year 2000, you missed out on a stock that returned several times its original cost.
If you replaced it with a tech flyer like Nokia for example, you ended up losing money, and missing out on Johnson & Johnson. If you had simply sat tight, you would have actually made money. That difference between what you could have achieved by patiently holding on to Johnson & Johnson and the actual result from buying Nokia in 2000 is your opportunity cost. Some may call this behavioral cost as well. Chasing what is hot, which is what following Nokia or other red hot tech darlings were in 1999 – 2000 was a big cost to investors.
3) Behavior costs are costly
I have personally fallen for behavioral costs. I have seen companies that seem to suffer through some issues, and I would sell them. Then these companies would miraculously recover and returns would revert to the mean. The companies I replaced them with either turned out ok, or they didn’t do as well.
I have also ended up selling companies because I thought they were too high, and replaced them with something else. You live and you learn.
At the end of the day, a lot of investors fall for the idea that you won’t go broke taking a profit. The problem is that you won’t get rich either. That’s because if you look at the Paretto principle, 80% of results would be concentrated in the top 20% of companies. In other words, if you sell too early from these 20% of companies that generate most capital gains and dividends, you are shooting yourself in the foot. And if you replace these companies with bad ones, you are compounding your mistakes.
Peter Lynch describes it as “cutting the flowers and watering the weeds”.
Investors tend to trade a lot in general, chasing what is hot, and selling what is not. At the end of the day, they end up consistently buying high and selling low, which turns out to be costly for long-term returns.
While the study does sound plausible, the reality is that it does not exist. It is just a popular piece of Wall Street Folklore.
However, it does confirm my observations that your portfolio is a like a bar of soap – the more you handle it, the smaller it gets.
You can read more about my observations in the four articles referenced below:
- Corporate Leaders Trust - No new investments since its launch in 1935
- The performance of the original companies in S&P 500 from 1957
- Stocks that leave the Dow tend to outperform after their exit from the average
