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Common Investor Mistake No. 3: Overtrading

Huw Aaron
Huw Aaron

Huw Aaron

Overtrading: You buy and sell stock too often, jumping from one hot company to the next big thing and paying way too much in commissions and transaction fees every time you change your mind. The name “overtrading” suggests it’s a mistake, but it doesn’t tell us why.

Researchers began to gather data on household trading in the early 1990s. It soon became apparent that, contrary to economic theory, humans do not behave rationally as they try to maximize their own material welfare.

A landmark study published in 2000 showed that retail investors who actively traded in common stocks performed markedly poorer than the market. The paper showed that the most active investors got 11.4 percent returns on their portfolio, while the market rose 17.9 percent.

A subsequent report on Taiwanese investors showed that they lost the equivalent of 2.2 percent of Taiwan’s GDP per year through overtrading.

That is, they would have gotten far, far richer by investing in an index fund and doing nothing. Their trading undermined their efforts to accumulate wealth, and yet they did it anyway, more attached to the notion that they had an edge than they were to concrete results. Subsequent studies of equity traders have only confirmed the pattern.

When the market is rising, big gains may soften the hurt of below-market performance, and if those gains are large enough, they may even satisfy the average investor. When the market crashes, of course, even above-market performance can be disastrous, and its relative superiority to the market average is cold comfort.

In addition to the higher spreads and commissions, and the worse performance, overtrading may also lead to higher taxes. In taxable accounts, holding investments at least a year can boost returns, but trading stocks too quickly can expose you to taxes you might otherwise be sheltered from.

There was an old saw that made the rounds in the 1920s, “Wall Street begins at a river and ends at a grave yard.” Anyone who has walked its length knows this is true. The East River runs the length of Manhattan to meet the Hudson at the island’s southern tip. The graveyard is Trinity Cemetery, attached to an episcopal church of the same name.

In a metaphorical sense, the river represents investors’ money and the graveyard their fate. Wall Street taps the river by spreading false hope through constant hype. I probably don’t have to name the TV shows out there hawking investment tips. They deliver adrenaline and a feeling of conviction much better than they do results.

In 2012, 41 percent of all United States households owned individual equities through their Individual Retirement Accounts (IRAs), according to an ICI report last year. And individual equities, of course, means that at some point, someone decided one stock was better than all the rest.

According to the same report, Exchange-Traded Funds (ETFs), a favorite of index-fund mavens, are used by investors with at least double the average U.S. households income and eight times their net wealth. That said, ETFs are still underused compared to high-fee mutual funds, given that they’re a relatively recent investment vehicle.

Everywhere you look, you can see investors ploughing their money into inefficient, low-return, expensive investments, and doing so by their own free will. As Benjamin Graham, Warren Buffett’s mentor, said: “The investor’s chief problem — and even his worst enemy — is likely to be himself.”

This is the third installment of a six-part series. Read Common Investor Mistake No. 1: The Home Bias Trap here and Common Investor Mistake No. 2: Bad Tax Split With Your IRAs here.

Simon Moore CFA, MBA, is chief investment officer at the award-winning retirement service FutureAdvisor. FutureAdvisor provides an online service to analyse and improve upon your retirement savings choices. It only takes a few minutes. Get your free analysis at www.futureadvisor.com.

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