From the June 19, 2005 Break Out Report
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Made Butter:
How
people decrease their returns by churning their accounts
by Marco den Ouden
"The investor's
chief problem, and even his worst enemy, is likely to be himself."
- Benjamin Graham
Unscrupulous brokers are sometimes charged with betraying
their clients with a practice known as churning. Simply put, it is when
a broker who is given discretionary management of an account trades his
client in and out of stocks excessively. The trades generate handsome
commissions for the broker, but they often leave the portfolio flat.
Either the trades made are poor or much of the profit (if there is any)
is eaten up by commissions.
Churning is generally considered to be an action that is
abusive to the client, and sometimes it is actionable and results in law
suits and even criminal charges.
But studies have shown that the advent of online trading and
the popularity of day trading has led to what might be called home-made
churning. Terrance Odean and Brad Barber, two professors in the Graduate
School of Management at the University of California at Davis published
a study in 1999 showing that investors generally trade too much to the
detriment of their portfolios and the ease of trading online has only
exacerbated the problem.
In Do Investors Trade Too Much? they analyzed trading
records for 10,000 accounts at a large discount brokerage, almost
100,000 transactions altogether. They discovered that, on average,
stocks purchased underperformed stocks sold to finance those purchases.
In other words, the investor would have been better off holding on to
his stock rather than trading into a different one.
Looking further into the nature of this excessive trading,
they discovered that investors tend to sell their winners and hold onto
their losers. They use the proceeds of these sales to buy into the
tail-end of a momentum stock then hang on for the ride down. (It's
happened to me, so I know what they're talking about.)
Even when eliminating trades that might be motivated by
liquidity demands, tax loss selling, risk reduction or portfolio
rebalancing, the results remain. Trading lowers returns.
Odean and Barber also note that men tend to trade more often
than women in their study Boys Will be Boys, and as a result,
women outperform men with their portfolios. Men trade 45% more than
women and earn annual risk-adjusted net returns that are 1.4% less
annually. The difference is even more pronounced comparing single men
and single women. Single men trade 67% more and earn 2.3% less than
single women. The difference, they note, is not that women are better
stock pickers but that they trade less often.
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In Trading is Hazardous to Your Wealth they studied
the activities of over 65,000 households with accounts at a major
brokerage between 1991 and 1996. They discovered that those who
traded the most
had an average annual return of 11.4% against an average return for all
households of 16.4%. The market returned 17.9%. The average household
turns over 75% of its common stock portfolio annually.
The families, on average, actually did do better than the
market return of 17.9% before transaction costs are
considered - 18.7%. But the transaction costs, brokerage
fees and bid-ask spreads, ate into those returns reducing
them to 16.4%.
Critics of the Barber-Odean studies have argued that,
because the period of the studies was between 1991 and 1996,
it doesn't take into account today's razor-thin online
commissions. But clearly, commissions can't account for the
fact that the return for the most active investors was only
11.4%.
In 2002, another of their studies, Online Investors: Do
the Slow Die First?, looked at 1607 investors who
switched from phone-based to online trading. They found that
those who switched usually outperformed the market by 2%
before switching, but "after going online, they trade more
actively, more speculatively, and less profitably than
before - lagging the market by more than three percent
annually". They attribute this again to overconfidence -
"the illusion of knowledge, and the illusion of control".
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Terrance Odean Addressing a Las Vegas Investor’s Conference, 2003 |
These guys are
university profs, so their studies are long documents of 40 - 60 pages each. Their prose is
generally readable, but sometimes abstruse, especially when they get
into mathematical formulae. You can find these articles as readable
short synopses and in their entirety at
Terrance Odean’s page at the University of California .
The lesson here, of course, is be careful and don't get
cocky. Investing is not easy. And it's not a game or a sport, though
some people treat it as if it is. You want to whip that cream into a
frothy, sweet and tasty treat - a profitable portfolio. Churn it too
much and you'll get butter!
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