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Trade a lot? Maybe you (and the pros you hire) shouldn’t!

April 25, 2014 by Editor, InvestingForMe

In our past couple of articles we’ve been looking at DALBAR’s latest studies listing 3 main reasons why many of us are such chronic underachievers when it comes to our investment performance. Here they are again to refresh your memory:

  1. bad investor behaviour
  2. high investment costs, and
  3. high investment Portfolio Turnover Ratios (PTRs)

This week we’re going to focus on #3 – high investment PTRs (otherwise known as investments that are traded a lot). The DALBAR studies conclude that if you actively trade your investments or buy an investment fund with a high PTR, then your rate of return will consistently fall short of the returns generated by stock market indices like our TMX or the S&P500 and Dow Jones.

So, who wants to carry on with this self-sabotaging strategy of picking high investment PTRs and continue showing up on DALBAR’s list of chronic underachieving investors? Not me, and neither should you!

Note: For a more detailed discussion of PTRs, see our previous article Practice safe investing.

High PTRs: indicator of timing-the-market players

When you encounter an investment fund with a high PTR, you can be pretty sure that the pros managing the fund’s investments are trying to time the market – buy low, sell high – one way or another. Market-timing is a risky business carried on by many investors who believe they’re smarter than the market and so practice frequent trading as if they’ve got some kind of crystal ball, knowing when to get in the market and when to get out. The strategy relies heavily on market forecasts of professionals, the analysis of past trading patterns, and is often used by investment advisors, financial analysts, and active investment fund managers in an attempt to reap the greatest rewards for their investor clients – you!

But does it work?

No, it doesn’t!

The reasons for the failure of market-timing strategies are many and varied, but some of the biggest reasons include the following:

  • History doesn’t repeat. Market-timing and active trading strategies assume that the past repeats itself into the future. With this in mind, active traders study past trading and market patterns, project them into the future and then make their trading decisions based on those projected patterns.
  • The future is unknowable. Active traders and investors that practice market-timing strategies believe they can predict the future. That future might be in 5 minutes, 1 hour, 1 day, or some longer interval, but they believe they know where a particular investment will be priced at the end of that interval.
  • Markets and market participants evolve. When you take past trading patterns and project them forward, you’re not only assuming that future market outcomes will be the same as past ones, but you’re also assuming that markets and market players will be the same. Nothing could be further from the truth! Markets and market players are constantly evolving such that today’s markets rarely resemble yesterday’s market and market players. For example, today’s markets are much faster, more global and more technologically sophisticated than they were in the past. Tomorrow’s markets will be even more so. Market players today are fewer and more concentrated, they trade at higher and higher speeds (i.e. high-frequency trading), trade with more sophisticated strategies (i.e. using complex mathematical formulas and algorithms), and they trade in a more opaque market (i.e. it’s estimated that 40%, maybe more, of daily trading now occurs off-exchange inside “Dark Pools”). So it’s a different game today, and tomorrow’s players will be different from today’s players.
  • For markets to function, every buyer needs a seller. Finally, if market-timing/active trading strategies were successful, there wouldn’t be a market! If the strategy worked and a certain pattern gave a signal to buy, wouldn’t everyone be buying? And by the same token, no one would be silly enough to sell, right? Think about it! For a market to function efficiently, on balance it needs a seller for every buyer, right? It just wouldn’t make sense if there were a magic crystal ball that there would be two investors analyzing the same investment, the same information, the same historical trading patterns, etc. where one decides to buy and the other decides to sell. And each, the buyer and the seller, must believe they made the correct decision. But, of course, somebody’s crystal ball would be wrong, and that is often the case unfortunately.

PTRs also don’t work for another reason. Not only do investments with high PTRs not generate increased returns for you, they can also decrease your investment returns because they often increase your transaction costs and can negatively impact your income taxes payable by generating taxable capital gains.

Do better: avoid high PTRs

DALBAR finds that active trading your investments actually hurts your investing performance, so for all those good reasons outlined above you should avoid investment funds with high PTRs.

So, to help increase your investment returns, analyze each of your investment fund’s trading activity (look for their PTRs!) and if you own a fund with a proven track record of high trading activity, then make the decision to switch out of it. Switch over to a fund that consistently avoids high trading activity – a fund that doesn’t follow a market-timing strategy, a fund with a low PTR. By making this simple change you’ll get yourself out of DALBAR’s chronic underachiever stats and get onto the better feel-good path of winning!

 

Read the first article in the series - The average investor: chronic underachiever

 

 

 

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