Dr Ajibola Awolowo
I have seen that look too many times to number. I have now come to expect and accept it. That look of disappointment and dashed expectations when a patient walks into the consulting room and sees me, a young medical doctor. They were hoping to speak with an older doctor. One with grey hairs all over their head. This is because it is widely believed, and rightly so, that older doctors have more experience, are more likely to be able to figure out what is wrong with their health and fix it.
There is a big possibility that an older doctor would have seen much more patients than a young doctor. The more patients they have seen, the better a doctor they should be. If you think this way as well, you are absolutely correct. Greater activity begets expertise.
This is true in many other professions as well. For instance, a mechanic that has fixed thousands of cars is likely to be much better than one that has only worked on a few hundred. An architect that has designed thousands of buildings is most likely better that one that has only designed 10. A teacher that has nurtured thousands of students has a greater possibility of being a better teacher than one that has only taught a few. I believe you should understand my point now.
Can the same be said in investing? Is an investor that has made 10,000 trades better than one that has only made 100? This is where things can get a little confusing.
In other professions or disciplines, it takes quite a lot of time to get job experience. The doctor with grey hair would have seen tens of thousands of patients but it would have taken him or her a lifetime to do this. The mechanic that has fixed thousands of cars would have also needed more than a decade to achieve this. The teacher who has taught thousands of students would struggle to have achieved this in a month or two.
To trade stocks however, all you need is an internet connection, a trading platform, some capital and your phone or computer. You can decide to place one thousand trades per day, per week, per month, per year or over a lifetime. How does the frequency of trading affect return?
A popular research was undertaken by students in the Graduate School of Management, University of California and published in 2000 titled “Trading is hazardous to your Wealth”. In this study, they collected data from a large brokerage firm about 78,000 households (investors) over a 6 year period (January 1991 to December 1996). From this data, they extracted how often trades were made and compared this with the returns these investors achieved over that time.
The results of this study are quite revealing. First, the average household (individual investor) had a turnover of 75% annually. What this means is that investors sold 75% of all the equities they bought within a year. This suggest that the average individual investor has a high volume of trades (buying and selling) annually.
Secondly, over this 6 year period, the index (aggregate performance of all listed equities) returned 17.9% annually. Investors who traded infrequently had returns of 18.5% annually while those who traded frequently returned only 11.4%. Frequent trading led them to significantly underperform, compared to investors who trade less frequently. Unfortunately, we do not have similar data for the Nigerian Market but I strongly suspect that findings in our market will be no different from the above.
The 7.1% underperformance in returns of frequent traders when compared to infrequent traders may look somewhat trivial on the surface but if this is compounded over prolonged periods, the massive handicap it delivers becomes apparent.
There are a few ways to explain why an increased frequency of trading leads to subpar performance.
The first and the most obvious reason is the impact of trading fees and commissions on investment returns. For every buy or sell transaction on the Nigeria Exchange, fees such as brokerage fee, Nigeria Stock Exchange (NSE) fee, Central Securities and Clearing System (CSCS) fee, Trade alert fee, Value added tax (on each of the above) and stamp duty is paid. These fees come down to an average of 2% of the total value of each buy or sell transaction.
For a trader to break even, he or she must therefore make a minimum profit of 4% after each buy and sell transaction. How feasible is it to consistently earn this minimum hurdle rate for each buy and sell transaction? Frequent traders win some and lose some but overall, those little losses they make leaves a huge dent in their portfolios.
Secondly, frequent trading requires frequent idea generation. When traders sell a company, they do it because they feel the price will decline and they buy because they feel the price will appreciate. Selling a company in order to buy another means the trader is trying to be on the right side of the trade, not just once but twice. If it was that easy to make money in the market, traders would be the richest and most successful players in the market. We know for certain that this is not true.
If frequent trading is detrimental to wealth, what then should we be doing?
First, we need to come to the realisation that buying shares gives one an ownership stake in a company. It is not just a commodity to be bought or sold at the flimsiest whim. When you buy shares, you become a business owner. You, therefore, need to start thinking as a business owner. Think about the car wash down your street, or the provision store close to you. Will the owner of those businesses sell the business today and buy it back next week? Or will they sell it today just because sales were down last month?
Hopefully, we now agree that business owners will not impulsively sell their businesses. In light of this, we need to be very conscious about the businesses we buy. A business operator will not buy a business they do not understand or know how to run. Having and sticking to a strict buy criterion makes business owners buy businesses sparingly, hold them for long periods of time and only sell if there are fundamental reasons to do so.
A friend of mine once said that shares should not be seen as “Inventory”. Inventories are current assets on the balance sheets of manufacturing companies. They consist of raw materials and finished goods that have not been sold yet. The greater the turnover in inventory of any manufacturing company, the better that company is. This is not true in investing. We should see our ownership of companies as long-term assets and not hot potatoes that are to be held only for a fleeting second and then dropped hurriedly.
Frequent trading may give you an adrenaline rush and get you pumped up. It will make you feel elated when you win and motivate you to try harder in recuperating the loss when the trade goes against you. Always remember, however, that there is a 4% minimum profit hurdle for each round trip trade and the annual 7.1% underperformance that frequent trading handicaps you by.
Dr Ajibola Awolowo can be reached via: valuenigeriawithajibola@yahoo.com