This is part four of my 10 things every beginning investor should know post.

#4 Turnover is costly

I touched briefly on this in part one so let’s go into more detail here.

Be wary of managers who buy and sell stocks like they would change their underwear. It’s the same thing with dating people who keep having partners, it’s a signal that these people have poor judgement or don’t know what they are doing.

Before we go into that, what exactly is turnover?

In general, turnover refers to transacting. Therefore, a turnover can be thought of as each buy and sell transaction. In evaluating a portfolio, investors can see how often a manager turns over the holdings in the portfolio but looking at something called the ‘turnover ratio’. Investopedia defines this as such:

The turnover ratio is the percentage of a mutual fund or other investment’s holdings that have been replaced in a given year…

There are a few reasons why turnover is costly. Firstly, transaction fees have to be paid each transaction. This means that for each buy and sell transaction, fees are twice.

Secondly, turning over means that investors incur taxes on short-term gains which are usually higher than taxes on long-term gains. While that may not apply here in Singapore since there is no taxes on capital gains, there is no reason to believe that Singaporeans only invest in funds that invest in SGX-listed companies.

Thirdly, even if the manager matches the returns on the market. With the additional fees paid when turning over a stock, it means that returns are compounded over a smaller base.

Fourth, turning over means that the manager must consistently find winners. It’s just pure odds. Let’s be generous and say that the odds of picking a winner are 50%. Having the manager pick just once means that the manager’s odds of picking a winner are 50-50. However, the more times a manager has to pick, the lower the odds (as a total) are because to pick two winners in a row would mean that the odds are 1/2 multiplied by 1/2 which now gives us odds of 1-in-4. Even if the manager has a secret sauce which increases his or her odds of picking winners, the odds that winners are picked must necessarily fall over time due to mathematical laws and as other market participants start to follow the same kinds of strategy.

To sum up, in the words of legendary economist Paul Samuelson:

“Investing should be dull. It shouldn’t be exciting. Investing should be more like watching paint dry or grass grow. If you want excitement, take $800 and go to Las Vegas…”

 

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