Benjamin Lederer
Neuro-economics

Better, Faster, Cheaper, Easier … and Worse?

By, 05/25/2017
Ratings894.011236

Earlier this year, someone placed a $100 million trade with a mobile app—that’s either a lot of trust in a cell network or a costly fat-finger. Advancements in online trading platforms have enabled investors to check their accounts virtually anytime anywhere, aside from the occasional subway tunnel or hiking trail. In the past five months alone, some discount brokerage houses slashed commissions as low as $5 per trade and the SEC reduced trade-settlement periods from three days to two. In short, trading is getting cheaper, easier and far faster. Investors can read an article about the next hot stock, fire up their brokerage app and buy within seconds. While convenience and low costs are essentially good things, it seems to me they also increase investors’ need to fight the urge to place myopic trades. Simpler trading can mean more trading, which studies show often leads to worse returns.

Trading stocks is way less of a hassle than it was 40, 30, even 20 years ago. Before May 1, 1975, trade commissions were a fixed rate per share, regardless of share quantity. So where you might have paid $100 to trade 100 shares, you would then pay $1000 to trade 1000 shares—despite the fact it likely wasn’t any harder for the brokerage to execute that larger quantity. The process was also far slower. First, you called your broker to place a trade order, which probably involved some phone tag and messages left with assistants. Your broker would then fill your order, which probably took a while since his traders had to go physically buy your shares on the exchange. Once it was all done, he’d call you back to tell you how much you owed, and you’d pay by sending in a check. Once they received payment, they’d draw up a stock certificate in your name and store it in a physical cage until it was time to sell (unless mob thugs broke in and stole it, which happened). Selling was equally cumbersome. Even as electronic trading took off in the 1980s, most orders still required a phone call. The New York Stock Exchange required companies to issue certificates until 2001.

The laborious process was one incentive against frequent trading. Cost was another. One broker claimed the average commission in the late 1980s, even after May Day ended fixed commissions, was $45, with some trades much more depending on the order’s size. As a general rule, the more expensive you make something, the less of it you get—high commissions were an incentive against frequent trading. They encouraged discipline.

As trading became cheaper, however, folks started doing more of it. According to TD Ameritrade, the average number of client trades per funded account annually was 11 in 2005. In 2015, this rose to 17.9.[i] Similarly, one Morningstar report shows that many index ETFs commonly considered “passive” instruments are held for less than one year on average. Not all of these trades are unwise, but as a general rule, the more you trade, the more you risk making mistakes.

Hence, cheaper and easier trading is a double-edged sword. Being able to trade from a ski lift with minimal friction is great, but it also makes it easier to fall prey to common behavioral mistakes. For example, have you noticed paying a tax bill of $1000 hurts a lot more than getting a $1000 refund makes you happy? Never mind that the latter is usually financially worse because you lent the government that sum with no interest all year.[ii] The same mindset drives many investors to take more risk than they should in order to minimize the chance of watching their portfolio slide—things like selling out after stocks have fallen a bit, then chasing heat during the rebound to get it back. The easier trading is, the easier reactionary trading is. Or, have you purchased an ETF with gangbusters recent returns, only for it to sag shortly after? With easy trading, you can flip from one to the next at your heart’s content, chasing your tail in circles. A lot of folks do. Or maybe you just saw a stock soar to record highs and sold it for no other reason than past performance, worrying it would soon revert to the mean—then tried to tune it out when it kept rising. All of these are behavioral issues innate to humans.

Many studies have linked frequent trading to lower investor returns, intuiting that folks often react poorly to market developments. A 2016 study by DALBAR, Inc. shows equity fund investors held their mutual funds for an average of just four years from 1996 through 2015. These investors averaged an annualized return of 4.7% versus the S&P 500’s 8.2% over that span.[iii] Now, there are some issues with these numbers, as they use fund flows to estimate investor returns. But still, it's illustrative. Another study at UC Berkeley found that most households from 1991 to 1996 earned a net annualized average return of 16.4% versus 17.9% annualized for the Center for Research in Security Prices’ broad US stock index.[iv] Further, accounts that traded frequently—monthly turnover above 8.8%—returned a net annualized average return of only 11.4%. The average household also turned over roughly 75% of its portfolio annually in that time frame.[v] Virtually any professional in this industry longer than a few months has seen investors trade too often, based on feelings and with poor timing. That’s a good way to shoot yourself in the foot.

It isn’t always a bad thing to trade, but the key is doing so for forward-looking reasons—not fear, greed or ones that hinge on the past being prologue. In the world of one-click, $5 trades, the role of a financial adviser becomes even more crucial to protect investors from their own short-term impulses. Investing can be emotional. A financial adviser should help you define your long-term goals and design a portfolio to achieve those goals. They may not always agree with your desire to trade, and that can be a good thing. After all, their job is to keep you on track to meet your goals and objectives, not enable you to chase heat. Good advisers may be the only protection left to investors in a future with free, instant-settlement, telepathic trades.

 

 

[i] TD Ameritrade. (2006 and 2016). 2005 and 2015 annual reports. amtd.com

[ii] This is especially true if you would have invested the funds or used them to pay down higher rate debt.

[iii] “Quantitative Analysis of Investor Behavior, 2016,” DALBAR, Inc. http://www.dalbar.com/.

[iv] For those of you who like long index names, this one is a delight: The CRSP NYSE/AMEX/NASDAQ Value-Weighted Market Index.

[v] Brad M. Barber and Terrance Odean, “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” Journal of Finance, April 2000.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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