End Wall Street's Tendency To Run Up Your Trading Tab
Maybe the devil made us do it. But then again, maybe it was Wall Street.
Many of us hurt our portfolio's performance by racking up hefty investment costs. Sure, that is partly our own fault.
But brokerage firms and mutual-fund companies also deserve a chunk of the blame. Ever eager to fatten their own bottom lines, these firms cajole investors into incurring excessive investment costs.
Here's how they do it:
Don't Stand Still
Newsletters frequently change their model portfolios. Brokerage-firm analysts constantly come out with new buy recommendations. Stock-market strategists are forever tweaking their suggested mix of stocks, bonds and cash investments.
All this advice is magnified through the media's megaphone and relayed in an onslaught of phone calls from brokers and financial planners. Combine this barrage of recommendations with the market's daily turmoil, and the din is almost unbearable.
Not surprisingly, many folks end up trading way too much. Wall Street lunches on the resulting frenzy, collecting brokerage commissions and making money off the bid-ask spread.
While you see just one share price in the daily newspaper stock tables, every stock actually has two prices, the bid and the ask. The ask is the price at which we can currently buy, while the bid is the lower price at which we can sell. Wall Street's market makers profit from this price difference.
All this trading, however, isn't quite so lucrative for ordinary investors. Consider a study by finance professors Brad Barber and Terrance Odean that appeared in the April 2000 Journal of Finance. The two professors looked at the performance of customers at a discount-brokerage firm over the six years through January 1997.
Their study found little difference in the pre-cost performance of those who traded the most and those who traded the least. But the difference in after-cost performance was staggering. The 20% of investors who traded the most earned 11.4% a year, while the 20% who traded the least garnered 18.5%. Meanwhile, the market returned 17.9% annually.
Don't Go Anywhere
While brokerage firms want us to buy and sell like crazy, many mutual-fund companies discourage their fund shareholders from trading. Instead, they want investors to sit tight and keep shoveling money into the company's funds.
Why is that? Fund companies don't make money when we trade. Instead, they make money by charging a percentage of the amount we have invested with the fund company.
Encouraging investors to hold funds for the long haul isn't bad advice. But it would seem a little less hypocritical if fund companies counseled similar patience among their own portfolio managers. According to Chicago fund researcher Morningstar Inc., stock-fund managers hang onto their stocks for an average of just 11 months.
Like fund companies, some financial planners and brokers also levy a percentage of assets. These advisers might charge 1% a year, equal to $1 for every $100 invested. Often, their clients also incur fund expenses, so that their clients' total costs might be 2% a year or more.
These fee-charging brokers and planners want as much of our money under their management as possible, so they can earn more in fees. Be warned: This may bias their advice.
For instance, it could make sense for clients to use a hunk of their savings to pay off their mortgage, open a 529 college-savings plan or purchase an immediate annuity. But unscrupulous advisers won't mention these options because it could reduce the assets they manage.
Don't Settle for Average
How can brokerage firms get us to trade? How can fund companies charge us more in asset-management fees? To bolster its own profits, Wall Street encourages investors to try their hand at beating the stock-market average.
As folks shoot for market-beating returns, they don't just trade with reckless abandon. They also choose actively managed stock funds, which might charge annual expenses of 1.5%, instead of market-tracking index funds, which might levy as little as 0.2% a year.
Despite such hefty costs, some investors manage to beat the market. But most people, unfortunately, fail miserably. Consider U.S. stock-fund results for the 30 years through year-end 2002.
According to calculations by Vanguard Group using Lipper data, U.S. stock funds returned 9.5% a year over that stretch, vs. 10.7% for the Standard & Poor's 500-stock index. The implication: Most investors would be far better off if they abandoned their market-beating efforts and instead purchased index funds.
Don't Go It Alone
Even as Wall Street urges us to shoot for market-beating returns, it also wants us to believe we are incompetent. This might seem contradictory. But it is a necessary part of the Street's marketing message.
After all, if all those brokers and financial planners are to remain gainfully employed, Wall Street must persuade investors that they desperately need an adviser's help.
But do we need help? I have seen studies that suggest ordinary investors do just fine, and I have seen studies that indicate investors garner terrible results. Not surprisingly, Wall Street likes to publicize the latter studies.
In truth, nobody knows for sure. But ponder this: If small investors really do earn results that are far worse than the stock-market average, then there must be another group of investors that is doing far better than average.
After over 17 years of writing about investing, I still haven't discovered who these wise men and women are.
My hunch: Like professional money managers, most small investors roughly match the market's results before costs and lag behind, once those costs are figured in.
Want to do better? Clamping down on costs would seem like a great place to start.
To contact Jonathan Clements, send an e-mail to jonathan.clements@wsj.com
Updated January 26, 2003 |
