Why A Do-Nothing Approach To Investing Is Often The Right Way To Go

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Here’s a great article at The Globe And Mail which illustrates how investors are hurting their returns by actively over trading in stocks saying:

“Trading is clearly the enemy of superior returns on a before-tax basis. This is doubly true in the after-tax world in which we all live.”

Here’s an excerpt from that article:

Have you ever come across an article in the financial press recommending a do-nothing or “couch potato” stock portfolio? Typically, such portfolios consist of either an exchange-traded fund or one or two of the largest capitalization companies from each sector on a stock exchange. Once the investments are made, they are left alone for many years.

Perhaps you think this approach sounds too simplistic to be effective. However, for the majority of investors, a long-term hold strategy will provide a better return than an actively traded portfolio.

When it comes to buying and selling stocks, we are all hard-wired to do the wrong thing. Our costly cognitive biases include being overly confident in our ability to predict the future, assuming that the direction in which a stock price is currently moving will continue for some time and allowing ourselves to be far more affected by a loss than by a gain of the same amount. One of the best-known studies demonstrating our inability to trade successfully is by Dalbar, an evaluation company. Each year, Dalbar compares the investment return of the S&P 500 to that of investors trading in and out of mutual funds invested in that stock index. Inevitably the return of the investors falls far below that of the index – and the difference is significantly more than the fee charged by the mutual funds. This behavioural drag on returns also applies to trading in individual stocks. While it may be counterintuitive, all independent studies show that the more you trade, the lower your investment return will be .

Trading is clearly the enemy of superior returns on a before-tax basis. This is doubly true in the after-tax world in which we all live. You pay capital-gains tax only when you sell an investment. Until then, the value of your capital is compounding tax-free. Deferring the payment of tax effectively reduces your tax rate. Over time, this results in a significant increase in the amount of your capital.

Not surprisingly, some investment professionals who earn their living from active trading have expressed doubt about long-term hold strategies. As U.S. author Upton Sinclair commented many years ago, it is difficult to get someone to understand something when their salary depends on their not understanding it.

An alternative to denying the success of this approach is to learn from it and perhaps adapt it. We believe an intelligent investor should be able to select a better portfolio than one consisting simply of the largest companies in each sector. History teaches us that the largest capitalization companies are prone to underperform the market.

How might you construct a long-term portfolio? One way would be to identify, say, 10 companies that you believe will outperform the market – not over the next year or two, but for at least the next decade. You might confine yourself to easily understood, steadily growing businesses in sectors that have been around for a long time and appear unlikely to experience major change. We believe that some sectors are likely to outperform others. Consumer packaged goods and enterprise software businesses have outperformed energy and mining businesses over the past 20 years. We think this likely to continue.

Your portfolio might also include holding companies, such as Berkshire Hathaway Inc. or Markel Corp., that have a successful track record of investing in other businesses. In this case, you would be relying on the ability of current and future management to allocate capital efficiently, without charging a fee for that service. A Canadian bank could be added to the mix, on the theory that these businesses will continue to operate in a regulatory oligopoly and will evolve to take advantage of technological change. Some investors would also add businesses, such as Alphabet Inc. (Google’s parent company) or Amazon.com Inc., that appear likely to continue to benefit from the internet economy for years to come.

At this point, you may be saying to yourself, “how can I possibly know what is going to happen in this rapidly changing world? Don’t I want to stay light on my feet, to be able to jump in and out of the market, anticipating future changes?”

These are valid questions. However, they may indicate overconfidence in your ability (or anyone else’s) to predict the future ahead of other investors. Quite apart from the expensive behavioural biases mentioned earlier, it is worth remembering that whenever you sell, someone else (who is not necessarily less informed than you) is buying – and when you are buying, someone else is selling. Are you sure you are smarter than the other market participants?

The broader stock market is likely to produce an attractive total return over any period of 10 or more years – and to beat most actively traded portfolios. If you enjoy buying and selling stocks, try this exercise – compare your after-tax investment return in 2017 with the return you would have enjoyed had you made absolutely no change to your portfolio during the year. The majority of investors would have done better in 2017 – and in every other year – had they elected to sit on their hands. As Warren Buffett has said, “Inactivity strikes us as intelligent behaviour.”

Most people will reject a rigid “never sell” investment approach. However, a thoughtful long-term hold strategy leading to extremely low turnover is, over time, likely to result in a superior investment return.

You can read the original article at The Globe And Mail here.

For more articles like this, check out our recent articles here.

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