1.5 Percent Is A Rounding Error, Right?

The World’s Most Expensive Hobby (Part 4)

Key Points

  • Households directly hold a significant percentage of stocks, close to 40% of the U.S. equity market.
  • But the average household gives up about 1.5% a year in performance through unproductive trading.
  • Such underperformance can lead to substantial differences over an investment lifetime.

Professionals trying to beat the market have limited success, as we have discussed in the past. But surely the average investor has a better shot since this group of individuals can be more nimble and impact conscientious then professionals on Wall Street? Let’s find out.

Trading Is Hazardous to Your Wealth

Households own about 80% of the U.S. stock market. About half of this ownership is through investments in mutual funds, pension funds, and insurance products, and the other half is though direct investments in stocks. Given that households are directly trading these stocks, in this post, we’ll explore the investment performance of such households and see how the numbers stack up.

In Part 2 of this series, we noted that investors that traded the most gave up about 7% in returns each year as compared to those that traded the least. This research was conducted by Brad Barber and Terrance Odean in their 1999 paper, “The Courage of Misguided Convictions”.

But not every investor trades excessively, so now let’s take a dive into the average investor, and see what happens. In a follow-up paper by Barber and Odean, published in 2000, we see that the average investor stands to lose ground as well.

The 2000 paper, Trading Is Hazardous to Your Wealth, examined the trading activity of 78,000 households from a large discount brokerage firm over a six year period ending in 1997. Similar to the researchers’ earlier work, households that traded the most gave up about 7% in returns each year.

The average household didn’t do as bad. In fact, before accounting for trading fees, the average household even beat the index. For the study, the index (or benchmark) was a value-weighted index of NYSE/AMEX/Nasdaq stocks, which returned 17.9% a year over the six-year period. This index is basically a basket of all the stocks in the U.S. equity market. And over this same period, the average household earned a gross return of 18.7%. Awesome, right?

Not so fast though. This 18.7% gross return does not account for fees, spreads, and commissions, all of which eat into returns. Turns out, once you factor in these costs, the average investor returned only 16.4%, which is 1.5% a year less than the index.

“It is the cost of trading an the frequency of trading, not portfolio selections, that explain the poor investment performance of households during our sample period.” (Barber 2000).

So it seems as if the average household is trading too much, according to this research. In fact, the paper further notes that the average household turns over more than 75% of its common stock portfolio annually, which can quickly add up to a large amount of fees per household.

Figure 1 below provides some insight of the impact of turnover and returns (Barber 2000).

2019-12-11-The World's Most Expensive Hobby (Part 4)-Figure 1

As you can see from the figure above, the gross returns for investors stays stable as turnover increases, but the net returns go down dramatically as turnover increases. This implies that excessive turnover erodes returns due to trading costs.

But note that the low turnover quintile (i.e., the bottom 20% of investors in terms of turnover) on the left in Figure 1 has the highest net return. This implies that if you want to maximize your net returns, it’s sensible to buy and hold rather than trading frequently. This is a key principle of Investing Forever, i.e., when you invest, plan to invest for a long time, and you’ll increase your chances of having the markets work for you rather than against you.

Peanuts?

Let’s see what a 1.5% underperformance can do to a household’s returns over an investor’s lifetime. In Table 1 below, we show three hypothetical scenarios.

In Scenario 1, we show the growth of $10,000 starting in 1974 though the end of 2018 for an investment in the S&P 500® Index (with dividends reinvested). This is a hypothetical return since you cannot directly invest in the index itself.

In Scenario 2, we show the growth of the same $10k over the same period, but now with fees of 0.08% per year, which is a good proxy for what an index fund might charge you today. Although, I would argue you can pay much less in fees today than even this small amount, the conclusions that we draw below will still stand.

In Scenario 3, we show the growth of the same $10k over the same period, but now with an underperformance of 1.5% a year, which attempts to approximate the performance of the average investor discussed above.

2019-12-11-The World's Most Expensive Hobby (Part 4)-Table 1
Table 1. Growth of $10k over 45 years (1974-2018). (Source: S&P Dow Jones)

Turns out over this 45-year period, the average investor in Scenario 3 would have trailed the Index Fund of Scenario 2 by about 47% by the end of this period. Yikes!

So let’s say that you plan to retire when you reach a million dollars. We’ll you’ll likely have to work much longer to make up that almost $500k hole in your account. So why not save yourself the trouble and just invest in an index fund?

This is why I consider active investing to be the world’s most expensive hobby. I’m sure building model trains or collecting stamps can get pricey. But all this pales in comparison to the amount of wealth that can disappear when an investor decides to actively invest. The risk is certainly worth taking into consideration, to say the least.

So the next time you’re thinking of taking up a new hobby, rather than active investing, might I suggest something more prudent like…pretty much anything?

To sum this up:

1) Most active investing professionals do not add value.

2) Non-professionals do not fair any better.

The grand effect of all this is to essentially transfer wealth from your pockets to Wall Street’s. So why on Earth are there so many active investors? People are people, I guess.

As the Saying Goes

Now what? We’ve seen that the professional active managers struggle to beat the index, and now we’re seeing that the average household has a similar fate. Given all this, is there a sensible solution out there for investors?

“Only you can manage your own money.”

I agree with this quote. It’s your money, and it’s important for you to know how it’s invested. But that doesn’t mean you need to actively manage your portfolio, there is a better solution out there, and that is to simply invest in index funds that are passive in nature and ones that closely align with your target benchmark.

If you’re ever in need of guidance, these blog posts may be of help. But be sure to contact a financial, tax, or legal professional for guidance and information specific to your individual situation. And as always you can reach out to me directly here with questions or concerns about your personal situation.

Finally, if you want to see how your portfolio stacks up, check out my risk assessment here.

The End.