MORE READING FROM MAY!
Copyright 1998 The Washington Post
The Washington Post
May 31, 1998, Sunday, Final Edition
Study Shows Merit Of Buy-and-Hold
By: James K. Glassman
After a week like the one just past -- with economic troubles deepening in Asia and Russia, bombs bursting in Pakistan, and stock prices bouncing all over the place -- you're probably tempted to sell some of your losers, cash in some of your winners and maybe trade them for some shiny new shares.
Don't.
Two finance professors from the University of California at Davis have just completed a study that confirms the sound principle of buy and hold forever. "Our central message," they conclude, "is that trading is hazardous to your wealth."
The term "trading," of course, means buying and selling stocks in anticipation of a stock rising or falling in the short term. It's a terrible idea -- because you incur transaction costs (including taxes), because trading usually takes you out of the stock market (at least for a short time, and often you dither before getting back in) and because traders just seem to sell at the wrong times.
The study by the two economists, Brad M. Barber and Terrance Odean, proves once again that Benjamin Graham, mentor to Warren Buffett and this century's greatest investment mind, was dead right when he wrote 50 years ago, "The investor's chief problem -- and even his worst enemy -- is likely to be himself."
Barber and Odean persuaded a large discount brokerage firm to provide them with data on stock trading by 64,715 customers from 1991 to 1996. The statistics were a gold mine. In fact, Odean told me that only one significant study has ever been done with similar investor records, and that was 20 years ago, with just 2,500 accounts.
What the two researchers found was that the average investor earned a gross return of 17.7 percent, compared with 17.1 percent for the market as a whole. So far so good. But the average net return, after transaction costs, was just 15.3 percent.
Far more important -- and chilling -- was that the 12,000 investors who did the most trading earned a return of just 10.0 percent while those who traded infrequently earned 17.5 percent. That's a huge difference. For the active traders, $1,000 grows to $6,700 in 20 years; for the others, $1,000 grows to $25,200.
Most of the investors in the study traded far too much. The average household, Barber and Odean found, "turns over more than 80 percent of its common stock portfolio annually." In other words, investors hold the typical stock for only 15 months.
The active traders registered a turnover of almost 25 percent a month, or 300 percent a year. They held the average stock for just 120 days.
The main reason for poor performance, the authors emphasized, "is the cost of trading and the frequency of trading, not portfolio selection."
In fact, the investors beat the market as a whole before transaction costs because they tilted toward small stocks and value stocks, which performed well in the early 1990s. But buying and selling incurred costs -- commissions, plus the loss on the spread between "bid" and "asked" prices -- that ate into their gains. (Taxes weren't taken into account in this study, though they would have depleted profits substantially.)
I asked Odean whether active traders could make up for higher costs with agile stock picking. He laughed. "There is some evidence" in this study, he said, "that high-turnover people are making bad choices -- poor timing on trades."
In two papers -- "Do Investors Trade Too Much?" and "Are Investors Reluctant to Realize Their Losses?" -- Odean looked at this question in more depth. He discovered that, when investors decide to dump shares, the stocks they buy "actually underperform those they sell." In other words, people who trade a lot make lousy decisions, switching out of good stocks and into bad ones.
Why? It's hard to say for sure, but Odean's research indicates that investors are especially likely to sell a stock if it has declined in the past and then rises a little. (Does this sound familiar?)
In general, he says, "you hold on to your losers" because it makes you feel better that you haven't locked in a loss. You try to "minimize regret" by acting as if there is still hope. Then, when the stock rises -- even if you still have a loss -- you feel better about selling it.
The point is not merely that this pattern of selling and buying is a loser for investors; the point is not to sell at all.
The Odean and Barber study, titled "The Common Stock Investment Performance of Individual Investors," is available on the Internet at www.gsm.ucdavid.edu/odean. The authors found that trading, or churning, as I prefer to call it, is shockingly common.
The New York Stock Exchange reports that its turnover has jumped sharply in recent years. Last year's turnover was 69 percent (meaning that the average stock was held for 17 months), compared with just 46 percent in 1990 and a far cry from the 1950s, when turnover was in the teens. Turnover on the smaller-stock Nasdaq market was far higher -- 199 percent last year, for an average holding period of only six months.
Odean speculates that one reason for so much trading is the ease of buying and selling over the Internet.
But another reason, for which the authors' research provides strong evidence, is "the well-documented tendency for human beings to be overconfident." In other words, investors think they can time the market when the weight of the evidence shows they can't.
Odean told me that overconfidence grows as the market rises. "There's a self-serving attribution bias," he said, meaning that people take personal credit for their stocks' gains. In the old saying, they confuse genius with a bull market.
"In an up market," Odean said, "you're going to think, 'I'm a good investor! I'm a really good investor!' " That's true, he said, even if your stocks returned 20 percent in a year in which the Standard & Poor's 500-stock index returned 30 percent. Investors tend not to look at benchmarks.
So, brimming with self-confidence, investors are more likely to believe they can jump out of Intel Corp. and into Coca-Cola Co. at precisely the right time to make a killing. "If you are the smart guy who picked the last winner, then it makes sense that you think you can pick the next winner," Odean said.
In fact, a properly confident investor is one who understands that the stock market, over time, rewards persistence, not skittishness and hubris. You need to adopt the discipline to buy and hold -- or at least to own mutual funds whose managers have a low-turnover strategy.
They aren't easy to find. "The investment experience of individual investors," write Barber and Odean, "is remarkably similar to the investment experience of mutual funds." A study last year in the Journal of Finance by Mark M. Carhart found that the average mutual fund had annual turnover of 77 percent.
The most popular low-turnover funds are the ones whose portfolios mimic the S&P. These index funds own the 500 stocks in that broad market average, selling stocks only when the composition of the index itself changes or, heaven forbid, when investors rush for the exits in a panic and the fund has to raise cash for redemptions.
The biggest of these funds, the Vanguard Index Trust-500 Portfolio (1-800-662-7447), with more than $ 50 billion in assets and 1.4 million shareholders, has averaged just 5 percent turnover in the past seven years. If you had put $10,000 into the fund five years ago and then added $100 a month, you would have $37,961 today, according to the Value Line Mutual Fund Survey. The same investment in Fidelity Magellan, the largest mutual fund of all, with an average turnover of 126 percent annually, would have brought you $31,820, or 16 percent less.
Other good funds run by active but patient managers include Legg Mason Value Trust (1-800-822-5544), with a turnover of 17 percent and an average annual return in the past five years of a stunning 29 percent, compared with 23 percent for the S&P; the Nicholas Fund (1-800-227-5987), with a turnover of 23 percent and a return of 20 percent; and Babson Growth (1-800-422-2766), which is a favorite of Sheldon Jacobs, editor of the No-Load Fund Investor (914-693-7420) and has a turnover of 19 percent with a five-year return of 19 percent.
All these funds carry lower risk than the S&P 500 as a whole, a frequent bonus investors derive from managers who lack an itchy trigger finger.
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