| Why long term investment is better |
I believe it is essential that investors take a long term view, and avoid trading. There are many reasons why I feel this way:
| Tax efficiency of long term investment |
It is ironic that it is mostly the same people that like to trade their funds around in the shortest period of time that also are most interested in aggressive tax planning strategies, because they hate paying tax.
The Australian capital gains tax system rewards long term investors, and penalises short term ones. If an investment asset such as a share, managed fund or real estate is held for less than one year, any capital gain is assessed at the investor's highest marginal tax rate. Hold on for just over one year, and you get a 50% tax discount, so you only pay tax at half your highest marginal tax rate. At least some investors appreciate that, but they fail to appreciate that if you hold an even longer period of time you'll get even better results.
If you can invest your money and achieve a 10% capital growth, but you sell every two years and incur capital gains tax, if your highest marginal tax rate is 48.5% you'll end up turning $10,000 into $43,800 over 20 years, even with the 50% capital gains tax discount. If you could hold that asset for 20 years though, and not realise any capital gains tax until the end, you would get $53,400. This extra $10,000 comes to you because every time you realise a capital gain, you have to pay tax on it, and you send this money off to the tax office with your next tax bill. The longer you hold on to the asset, the longer you get to hold on to your capital gains tax liability and leave it in the market where it earns you money. It is like a long term interest free loan from the Australian Tax Office, and all you have to do in order to get this loan is extend your holding period.
For the record, a trader that achieves a 10% growth but realises the profit every year pays a much higher rate of tax and will end up after 20 years turning $10,000 into a mere $27,300. A short term trader would need to achieve a pre-tax profit of 17%pa in order to get the same profit as a long term investor getting 10%pa over 20 years. Now I can accept that through luck or skill some traders (a small minority) can beat the market, but achieving a return almost double that of investors and keeping this up for 20 years is a feat I've never heard of - and all that would give you is performance equalling that of a passive investor. In practice, the trader would need to do even better to make his or her efforts worthwhile.
It should be noted that index funds usually have a much lower turnover than active funds, which results in them making far fewer capital gains distributions. As there are less distributions, less capital gains tax is paid. Many active funds turn over 100% of their portfolio every year, which results in very poor tax efficiency.
| The costs of short term vs long term holding periods |
In several studies, Terry Odean and Brad Barber examined tens of thousands of accounts, incorporating millions of trades at two discount brokerages. Odean and Barber found a strong negative correlation between trader turnover and success. As you might expect these amateur traders performed significantly worse than the market on average. The 20% of traders with the highest turnover had the worst performance, while most traders underperformed the market by a few percent, the most active traders managed to underperform the market by a massive 7%pa (S&P500 index return over the period studied: 17%, most active traders: 10%).
Trading is expensive because there is much more to costs than just brokerage, which these days is less than $20 a time on the Internet. Odean and Barber found that brokerage was a minor expense, compared to the bid/ask spread.
When you want a quote for a stock on the market, there are really two numbers that apply. The bid is the price at which somebody wants to buy your stock. The ask is the price at which somebody else is offering to sell their stocks to you. On the largest and most liquid stocks this spread could be less than a percent, but on the really small stocks for which there is little trading activity the spread can be huge. As most of the traders in the study focused on smaller stocks and "value" stocks, they usually had to overcome a large spread.
This gap, easily a few percent in many stocks, needs to be crossed every time you want to exit a position. If the bid of a stock is $1.00, but the ask is $1.05, you'll need a 5% capital gain before the bid gets to the price where you bought it. Multiply this by hundreds of times and you see the kind of appreciation that a day trader needs before he or she can break even.
Trading is significantly harder work than investment because long term investors don't need to worry about the bid/ask spread as much, they only need to cross it once in many years, during which time the stock has presumably moved a great deal more than a few percent.
Combine the market costs of trading with the tax costs of trading and you can see it is a doubtful proposition: you need significant gains just to break even, but in order to make the same after tax profit as a long term investor you need very high trading profits on top of that. Factor in the argument from the previous article that you need to be way above average to beat an index after costs, and it is obvious that the number of profitable traders out there will be very small compared to profitable investors, and the latter don't even have to work very hard.
| Risk is reduced by holding on for a longer period of time |
The stock market is very volatile. That much is well known to practically anyone that has ever seen a stock price chart. There are lots of measures of risk, but the single number most usually called on to measure risk is the standard deviation of returns, a statistical measure indicating how widely returns are spread around their averages.
Double your time in the market, you can expect twice the return. Quadruple your time in the market, you can expect four times the return. But volatility doesn't scale up in the same way. Volatility, on average, increases as the square root of time. If you double your holding period you'll have twice the return, but fluctuations only sqrt(2)=1.4 times as great. Hold four times as long, you expect four times the profit, but the volatility of returns over this period would be sqrt(4)=2, twice as much. The longer you hold, the more favourable this risk/reward ratio becomes, volatility becomes virtually insignificant compared to capital gains over time, but you need to hold for many years.
In contrast, consider the trader. Traders need profits far above that of an investor to overcome tax and expense disadvantages, so the trader needs to take more risks. On a short time frame, the bid/ask spread becomes huge compared to potential profits, and brokerage is much more significant. The trader needs to adopt a very careful discipline of cutting losing trades short and holding winners as long as possible, to increase the relative size of winners compared to losers.
This is essential because costs always add to losses and subtract from profits, it is quite easy for traders to incur much larger losses than profits. Furthermore, even the most successful traders usually have a terrible win:loss ratio, they tend to close more trades at a loss than at a profit, which is why it is so important for them to make their winning trades really profitable.
How do you make your winning trades that profitable? Usually with substantial doses of leverage, and frantic trading on every move in order to compound their investment as fast as possible. Many traders make a living on the razor's edge, dealing with a variety of derivatives and speculative stocks that have the potential to take the trader's head off at any moment.
Traders can assess their performance with a formula called "Risk of Ruin" (a concept borrowed from gambler's money management). The formula is more complicated than I'd like to get into right now, but it is a function of the ratio of profitable trades to unprofitable trades, the average loss vs average profit and the largest loss the investor is willing to withstand before calling it a day. The better these statistics are, the lower the risk of ruin calculated by the formula. Very few traders are able to maintain statistics good enough to produce a risk of ruin below 25%, which is considered the maximum acceptable number for prolonged speculative trading (and even then many say it is too high).
The ratio of winning trades to losing trades and average loss vs average profit is almost always excellent in long term buy and hold investors, over longer periods of time profitability becomes close to 100% certain in a diversified portfolio, and the potential for upside profit over a long period of time is significantly greater than the potential for loss. Risk of ruin, for long term diversified investors, is almost nothing.
| The dramatic consequences of not investing long term |
A research organisation called Dalbar Inc. has been studying the performance of US mutual fund investors for some time.
As I demonstrated in the previous article on actively managed funds vs passive index funds, the majority of active funds underperform. In the United States, the typical large companies mutual fund has underperformed the benchmark S&P500 index by about 3%pa. Mutual funds investing in bonds, real estate and other sectors have also underperformed their respective benchmarks by a fairly similar amount.
Those are the figures for a buy and hold long term investor. If you went back 20 years ago and invested your money in a portfolio of every single actively managed fund, and invested in new funds when they become available, you'd have underperformed by at least 3%pa, possibly a little bit more when you take into account survivorship bias, another effect mentioned in the active funds article.
But hardly anyone invests like that. Investors pile in on the back of strong markets, pull out during periods of market weakness. In fact, if you chart historical US mutual fund inflows and outflows against the market you find almost perfect ineptitude in investor's timing, funds pour in to the greatest extent when markets are at or near highs, funds are withdrawn at an alarming rate near market bottoms. Morningstar US claims that in recent years, the average holding time for US mutual fund investors has been less than three years, definitely not buy and hold investment.
Dalbar Inc. very closely tracks these figures on a fund by fund basis, and their research has demonstrated that investors underperform their underperforming mutual funds by an enormous amount. They don't just do 3 to 5% worse than indexes, as you'd expect by looking at average mutual fund performance data, they actually do substantially worse than that.
DALBAR, Inc. have been tracking retail investors since 1984, in the 1997 update of their Quantitative Analysis of Investor Behaviour Study, they concluded that:
“Mutual fund investors earn far less than reported [fund] returns due to their investing behaviour. In their attempt to cash in on the impressive stock market gains, investors jump on the bandwagon too late, and switch in and out of funds trying to time the market. By not remaining fully invested for the entire period, they do not benefit from the majority of equity market appreciation.”
How much did they underperform? The following chart shows the performance of private (DIY, not clients of advisors) US mutual fund investors over the period of 1984 to 2000, the figures came from Dalbar's 2001 update.
Dalbar have studied the performance of DIY investors (shown here) and "advised" investors, the clients of financial advisers. The data showed that the clients of financial advisers did do marginally better than DIY investors, though this was entirely due to longer holding times. There was no evidence to show that financial advisers were any better or more skillful at fund picking, just that they managed to convince their clients to hold on a fair bit longer and time the market less.
Nevertheless, advised clients were soundly beaten by both the average mutual fund and even more so they were beaten by the indexes. Investors that simply bought index funds and held them for 20 years would easily have been in the top few percent and would have done a lot better over the years than either DIY fund pickers or the clients of financial advisers recommending active funds.