While many people still prefer the "fire and forget" nature of investing in mutual funds, more and more people are rediscovering the excitement and benefits of trading individual stocks. No doubt, this has been aided by the growth of online trading, cheap commissions and a realization that many high-paid advisors and Wall Street research departments consistently fail to outperform low-cost mutual fund strategies.
But with investors' newfound status as managers of their own portfolios comes a dangerous temptation – overtrading. In fact, overtrading can represent a far greater risk to a portfolio than mediocre stock selection or a bad market. Time and time again, undisciplined and hyperactive investors run their portfolios into the ground by increasing their costs, decreasing their tax benefits and missing the natural action of the stock markets. Getting a grip on how often they pull the trigger is crucial in keeping their portfolio moving in the positive direction.
How Heavy Trading Cuts Profits
If Wall Street's full-service brokers traded their clients' accounts as heavily as many do-it-yourself investors, they'd be accused of churning and lose their licenses. The reality is that $10 self-service commissions can do just as much damage as $30-50 full-service trades if they're done five to 10 times as often - something many novice traders don't realize until they sit down and add up their first few months' trading costs. As a rule of thumb, an investor hoping to earn double-digit returns should seek to limit her/his portfolio's annual costs to between 1% and 2% including all commissions.
The Bid-Ask Spread
Trading costs aren't the only thing nickel-and-diming individual investors to death. The bid-ask spread, or the built-in difference between the level at which a buyer and seller can transact a share of stock, can quickly bleed a heavy trader dry in a flat or down market. While Wall Street's largest stocks typically have a very narrow spread between the bid and ask prices, it still can amount to one-tenth of 1% per trade. While that may not seem like a lot, the bid-ask spread can easily cost a heavy trader as much as 2% of a portfolio's value over the course of a year. Considering that many do-it-yourself investors also like to speculate on small companies, where the bid-ask spread can be as high as 5% per trade, it's not hard to see how heavy trading can be an anchor around a portfolio's neck.
Of course, many investors are blessed with some combination of skill, luck and good timing, and they manage to post solid returns in spite of the high trading costs and the bid-ask spread hurdle associated with heavy trading. For these investors, hard work and good fortune are often punished with a higher tax rate than for those who buy their investments and hold on to them over longer time periods.
The U.S. tax code taxes gains on all assets held for less than 12 months at ordinary income tax rates. That means that at 2013 federal tax rates, up to 39.6% of a heavy trader's gains can go to taxes. This stands in stark contrast to a buy-and-hold investor whose long-term U.S. capital gains rates max out at 20%.
How Slower Turnover Builds Profits
It's not just that heavy trading can take its toll on a portfolio; it's that the absence of lower turnover can also rob a portfolio of valuable components.
Trying to follow every up-and-down tick of your favorite stock, plus all the news headlines that could affect that stock, can leave many investors feeling a little strung out. As a consequence of being overloaded, many investors' psychology becomes more erratic, and they make investment choices on adrenaline and impulse. Trying to time trades distracts many investors from doing critical research.
Whether they are technical traders who need to put in time with their charts, or fans of fundamental analysis that need to put their potential holdings under the microscope, overtrading can be a fatal distraction. By lowering their turnover rate and investing their limited time picking better companies, many lower-turnover investors end up outperforming their heavier-trading peers.
Perhaps one of the biggest missed opportunities of maintaining an extremely high-turnover portfolio is missing regular dividends and unexpected stock splits. Dividends, especially, have proven to provide a potent share of investors' overall total return historically. In fact, some studies estimate that dividends account for as much as half of the overall long-term growth of major large-cap indices such as the S&P 500 and the Dow Jones Industrial Average.
Alternatives to Heavy Trading
Whether you've got the itch for some fast action or the hankering for some incremental return, there are more efficient ways to reach your goals than heavily trading your account.
If you're determined to be the shot caller on which stocks end up in your portfolio and when, be sure you're significantly diversified. Not putting all your eggs in one basket can actually lead to less micromanagement since all of your net worth is not tied up in the next trade. Even though you may make roughly the same amount of trades as before, they'll be spread over more companies, lowering the actual turnover of each position. In turn, you may cut down on some of the previously mentioned pitfalls such as shorter capital gains holding periods, missing dividends and stock splits, and becoming a high-strung trader who's got everything riding on just a few positions.
If you're open to turning over the reins to someone else, consider using an actively managed mutual fund that focuses on high-turnover strategies, or even a "separately managed account" if you have $100,000 to $250,000 to invest. In both of these situations, you'll get the joy of knowing someone is actively working the market for you, but likely doing it with more expertise and lower costs than if you tried to do it yourself.
Last but not least, consider utilizing a covered call-writing strategy, especially with assets that are in tax-protected IRAs. By writing covered calls, or selling someone the right to possibly buy your stock in the future, you can increase your portfolio's overall return in an exciting hands-on way, while lowering your turnover significantly in flat and down markets.
The Bottom Line
While many investors dream of being active traders, it's a costly and time-consuming lifestyle that can cause your net worth to evaporate over the course of a couple of poorly timed trades. If higher returns are what you seek, consider slowing down your turnover, spending more time on research and utilizing some creative strategies to keep your portfolio's return exciting.