Long term investing is risky

By | January 23, 2014

It is common to hear that long term investing, usually defined as five years or more, is the panacea for the risks involved in investing in equities. “Invest for the long term” is a nice cozy assurance that your investment will always pay off as long as you give it enough time. But just by looking at the return of the All Ordinaries Index from the period of March 1950 to December 2013 it can be seen that a five year investment horizon is no guarantee whatsoever of positive market returns (let alone a single stock, which can be infinitely more volatile).

Over one year periods the All Ords has returned between 80.3% and -45.4%. Extending the time frame to the mentioned  five years the best result was an impressive 367% gain (36.1% per year compounded), however the worst result was a 54% loss (14.5% per annum drop). If we take ten years, the best result was 22.7% a year, but the worst was a 3.4% per annum loss. Over 15 years it was still possible to be down 0.9% per year, meaning that over fifteen years an investment would have returned a total loss of 2.6%. This is depressing because 15 years is ultra long term in the eyes of many people, so still be losing a substantial amount of money in such timeframe is intolerable. So yes, long term investing is still quite risky.

Skilled long term investors take all of these into account and always try to time their entries, buying when the market has been bearish for a while. It has in fact been proven by extensive research that when the market has had a number of good/bad years a downturn/upturn is inevitable. The other option is to buy substantially undervalued companies with solid competitive advantages that should allow them to weather out any financial storm. Look for strong companies that are likely to still be on business somehow in 40 years from now and you are already half way there.

That said, you should still be continuously watching out for your shares. Read all the company reports and pay attention to any comments by management, news on acquisitions or big changes in profitability. Even blue chip companies make big mistakes and go bankrupt every now and then on some big blunder by management. This does not mean you have to read the FT or WSJ everyday or watch the daily fluctuations in price while having a heart attack listening to Jim Cramer on CNBC, but just that you should stay on top of the business situation.

In fact, the one factor you should not be paying that much attention to is the stock price volatility. Nothing is more contrary to the principles of intelligent investing than buying something because it has become more expensive or selling something because its price has fallen. Monitor the company, the accounts, the management, competitors and primary markets, but try if at all possible to ignore the daily stock price moves.

That sounds like a lot of work… and not particularly exciting. Isn’t it better to take a shorter term approach and get in and out of investments as you follow the markets?

Well, without getting into most people abilities to time the short term movements of the market, one of the very good reasons for investing long term is the tax benefit. While tax advantages rarely make up for poor investment choices, capital gains tax favors long term investing. This is because you only become tax liable once you actually sell your shares, so while the money stays invested it continues to compound tax free. If you sell often you have to keep paying tax every single year, giving to the government money that could otherwise be generating returns for you in the market. A capital gains tax liability is like an interest free loan from the tax office that you may never have to pay back, so you really want to defer it as long as possible. Over time, this can make a substantial different.

Another argument for long term holding that does not involve the tax man is that broker fees are fairly expensive, even if using a discount broker. Obviously the more often you trade the more you will be paying, with many frequent traders paying thousands of dollars per year in brokerage fees.

Slippage costs, like spreads of market impact, are another expense of regular trading. The spread is the difference between the bidding and asking price of a stock. For large stocks the bid might only be a cent or two but for very small stocks it can be considerable, 20% or more in an irregularly traded small-cap stock and hundreds of percent in some extremely speculative penny stocks. Every time you buy a stock you have to make the highest bid at that time to buy. When you sell you need to make the lowest offer for your sale to go through. Market impact refers to the fact that when you are buying a stock you are pushing up its price, so it is not uncommon that you execute part of your order at one price and the rest at less advantageous prices.

All in all, there are actually no advantages to short term holdings apart from the obvious potential to profit from speculative trading. Nobody can deny that the amount of people that make decent money investing long term outnumbers the amount of people that make decent money in trading by an enormous margin. Taxes, brokerage fees and slippage costs make it so much more difficult to be a successful short term trader.

So do people tend to hold for the long term? Well according to several industry studies, the average holding time for US individual investors in mutual funds is only 15 months. This is despite the (sensible) common knowledge that managed funds are best held over many economic cycles. I have not seen any statistics on individual stocks, but the average holding time is surely much shorter.

Timing success rates

A study of 100 large US pension funds found that while every single one of them engaged in a certain extent of market timing, non of them gained an advantage from it. Actually, 89 of the 100 were worse off as a result of attempting to time the market, incurring an average loss of 4.5% over a 5 year period from trying so.

The authors of this study (Jerome B. Bohen, Edward D. Zinbarg and Arthur Zeikel, Investment Analysis and Portfolio Management) concluded:

The evidence suggests strongly that mutual funds as a group are not successful at market timing activities. We believe the same would hold true for other groups of institutional investors, measured as a whole.

Of course many readers will not be put off by these comments, since after all they are mostly small amateur traders, rather than dumb institutional investors. Nevertheless the burden of proof always lies on the person claiming the ability to beat the market.

The costs of trading

If a group of people were to sit in a room and run their own little market, bidding for and selling some sort of security to each other, on aggregate the profits and losses made would be equal. Some would walk away wealthier, having been more shrewd or lucky than most, and some will have lost money to the others. This might lead to a certain amount of wealth transfer, but no wealth creation at all.

Now repeat the exercise, except that somebody acts as a broker and takes €20 from the buyer and the seller every time a transaction is made. The story would still on average be the same, no money will have been made or lost on average, except that a few lucky traders will have taken the money of the others, and of course the broker will have made a large profit. If you looked just at the trader’s accounts though you’ll see that the traders as a whole had lost money, there was a net transfer of money from traders to the broker.

If you look at this in terms of a game theory approach you will see that trading is thus a loser’s game, which means that there is no real way to win the game by skill and that the ideal strategy to maximise the wealth of the traders on average would be to do no trading at all, and thus have to pay less to the broker. The ideal strategy for a broker would of course be to encourage a lot of turnover, because every time somebody wants to make a trade the broker gets wealthier.

So trading itself generates no wealth at all. Remember if you will that there is a driving force behind share returns (retained business earnings + dividends) and property returns (inflation driven appreciation + rent) that does give an amount of profit to all holders. If every investor in shares and property were to hold their investments indefinitely, the amount of profit that would be realised by all investors would be equal to these investment profits minus tax. As soon as you start to introduce transactions the amount of profit that is made will be correspondingly reduced, to the profit of brokers, market makers taking the spread between bid and ask prices, taxes that are higher than they need to be due to regular capital gains events and all the other costs.

The remarkably high cost of trading and taxes

It is easy to find out how much of an advantage holding investment long term gives you over trading short term after including taxes and fees. My findings are that this edge is huge.

I used the following assumptions, all of which seem reasonable:

Long term capital gain rate 7%pa
Dividend yield 3%
Tax on dividend 25%
Investor’s marginal tax rate 48.5%
Cost to switch 1%

First, I checked how much money the various investors ended up with after investing €1,000 for 20 years assuming that each were able to get 7% in capital appreciation plus 3% dividends before costs. I looked at the following frequencies: annually, once in 2 years, once in 5 years, once in 10 years and once in 20 years.

Trading frequency After tax end result
Once every year €3,687.14
Once every two years €4,114.56
Once every five years €4,505.15
Once every ten years €4,804.17
Once every twenty years €5,172.24

Next I checked how much growth you’d need to get to compensate for your trading expenses (tax + 1% cost to switch). Traders usually argue that they market outperformance more than compensates for trading expenses, so how much better does a shorter term trader/investor have to do to make up for paying regular taxes and switching costs?

Trading frequency Capital gains required
Once every year 9.44%pa
Once every two years 8.61%pa
Once every five years 7.92%pa
Once every ten years 7.47%pa
Once every twenty years 7.00%pa

Conclusion: you have to be very very good to outperform over the long term while investing on a short term basis. Capital gains tax and switching costs (broker fees + slippage) take a substantial cut from your long term performance. You need to outperform the market by 2.5% every year to compensate for switching just once a year. If you are one of those people who change their stocks a dozen times per year tax efficiency may not get much worse, but you obviously need to make up for that 1% switching expense twelve times. I doubt that 99% of amateur traders are able to compensate for all those costs and maintain a decent track record over the years.

The stock market is a device for transferring money from the impatient to the patient. – Warren Buffett

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