The Dangers of Hyperactivity for Long-term Investors
Your portfolio is like a bar of soap, the more you touch it the smaller it gets
I've been reflecting on the significance of behavioural patterns when investing and felt compelled to discuss the dangers of overtrading for long-term investors like us.
A major challenge faced by many investors is the temptation to constantly buy or sell securities in response to market fluctuations or unsolicited opinions. This habit, usually fuelled by anxiety or the desire for results, can be detrimental to long-term success. To build a solid investment portfolio, we must break this habit and develop an investment framework that focusses on our long-term goals.
Investment legends offer valuable advice on this matter. Jack Bogle, the founder of Vanguard Group, strongly advocated for a buy-and-hold strategy, emphasizing the importance of staying the course and resisting the urge to constantly trade. He believed that a well-diversified, low-cost portfolio is key to long-term success, and that frequent trading only harms our returns. He has a few quotes that I have found instructive and often find myself repeating when I get the urge to check stock quotes or dip into my portfolio. He says that when people panic they usually shout “Don’t just stand there, do something” but Bogle rightly applies the Munger mental model of inversion to state that in the investment world, the advice should be: "Don't do something, just stand there!”.
"If you're not willing to react with equanimity to a market price decline of 50% two or three times a century, you're not fit to be a common shareholder, and you deserve the mediocre result you're going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations." - Charlie Munger
The right temperament is crucial for successful long-term investing. This involves having the patience, discipline, and emotional stability to remain focused on one's investment objectives, despite short-term market fluctuations or external pressures. A well-balanced temperament enables investors to make rational decisions based on sound financial principles, avoiding emotional sway from fear and greed. William Green in his book details a few strategies legendary investors use to deal with decision making.
Follow the HALT-PS methodology. Don’t make decisions when hungry, angry, lonely, tired, pained or stressed.
Keep a brain health checklist: meditation, exercise, sleep, nutrition.
When close to making an impulsive decision, take 10 deep breaths with your eyes closed and do something else.
Several renowned investors emphasize the importance of temperament in successful investing. Warren Buffett once said, "Success in investing doesn't correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing." This highlights that managing emotions and impulses is more crucial than extensive financial knowledge.
"I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches—representing all the investments that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at all." - Warren Buffett
Benjamin Graham also stressed the significance of temperament in his teachings. In The Intelligent Investor, Graham famously writes, "The investor's chief problem—and even his worst enemy—is likely to be himself." This statement eloquently summarises everything.
Don’t just take their word for it though.There is substantial evidence suggesting that frequent trading can lead to underperformance:
Fees: Excessive trading generates higher transaction costs like brokerage fees and commissions, which can erode returns, particularly for individual investors. A study by Barber and Odean (2000) found that those who traded the most underperformed the market by an average of 6.5% annually, partly due to increased transaction costs.
Taxes: Active trading can result in higher taxes, particularly for investors in higher tax brackets. Short-term capital gains are taxed at ordinary income tax rates, whereas long-term capital gains are taxed at lower rates. By trading frequently, investors may generate more short-term gains and incur higher tax liabilities, diminishing returns.
Behavioural biases: Frequent trading can lead to underperformance due to biases like overconfidence and the disposition effect. Overconfidence can cause excessive trading, while the disposition effect leads to suboptimal investment outcomes. Barber and Odean's study showed that overconfident investors, who traded more frequently, experienced lower returns than their less confident counterparts.
Market timing: Frequent trading can result in lower performance due to the difficulty of consistently timing the market. Numerous studies have shown that most active fund managers underperform passive, index-tracking counterparts over the long term. A study by Dalbar (2021) found that the average equity mutual fund investor underperformed the S&P 500 by 4.56% per year over a 20-year period, largely due to poor market timing decisions.
The evidence all suggests that frequent trading is associated with lower investment performance. By adopting a long-term, buy-and-hold strategy, investors can minimize these negative impacts and potentially achieve better returns.
"Everyone has the brainpower to make money in stocks. Not everyone has the stomach. If you are susceptible to selling everything in a panic, you ought to avoid stocks and stock mutual funds altogether." - Peter Lynch
Moreover, it's essential to recognize the influence of financial media on our decision-making process. Financial media (by this I mean CNBC, Bloomberg but also YouTube, Twitter, TikTok) often promotes short-term thinking and impulsive trading, encouraging viewers to take action with their portfolios. It's crucial to remember that our long-term investment goals should not be swayed by short-term market noise. Be conscious when consuming this media that it might be tempting you to fiddle with your portfolio.
It's no secret that fear is a powerful driving force in the media, especially when it comes to financial news. In this realm, fear and envy are the two emotions that truly capture attention. Some might argue it's greed, but Charlie Munger's perspective on envy being the primary motivator seems more accurate.
Nowadays, financial content creators often adopt a more personal approach, making their audience feel like they are friends sharing valuable financial information, usually about a highly speculative cash burning company being the next great investment. They then monetise this by enticing the viewer to pay a fee in order to join a chat forum where the notions presented in the video are pounded in further.
Many YouTubers create an atmosphere where viewers feel like they're part of a team or being let in on a secret. Unfortunately, this dynamic can mislead novice investors and encourage them to deviate from time-tested strategies for long-term investing. As a result, they may end up investing in risky, cash-burning companies or making hasty decisions based on sensationalised news. Ultimately, the content creators benefit from increased engagement and revenue, while inexperienced retail investors receive poor advice, underperform, and potentially become disillusioned with investing altogether. Sadly, I believe this was crystallised for many during 2021 and 2022 when the tide went out and they saw more of their favourite YouTuber than they bargained for.
If you are the type to feel the urge to fiddle often. I feel like a good course of action might be to remove almost all financial information from your smartphone. That way you are sheltered from the bombardment of stock quotes, notifications about dramatic news and hysterical talk of how many points the Dow has dropped or risen on any given day. I suspect you don’t get a quote on your house and car very regularly. Why would anyone need it for a part ownership of a business either.
Please feel free to share your thoughts on this subject. I look forward to our continued discussions on investing and the road to financial success.
This week I stumbled across an unlisted YouTube video of a fireside chat with Charlie Munger and Todd Combs that took place in April 2022.
I encourage everyone to listen to it, it contains some rare gems of Munger talking about investments, life and people he admires in a way that’s rare during interviews and meetings. He seems more relaxed and conversational. There were two great quotes that I wrote down:
Why would you expect that something everybody can see is a great company, of course they are going to bid the price up sir high that maybe its not such a good investment.
And:
I think the people who tend to get the best results are these fanatics who just keep searching for the great businesses.
Search on fellow fanatics!
Warm regards,
Oliver