There’s an old pilot joke about cockpit automation that says the ideal flight crew is a pilot and a dog. The pilot is there to feed the dog, and the dog is there to bite the pilot if he touches anything.
The same is true for investment portfolios. The ideal fund management team is a fund manager and a dog. The fund manager is there to feed the dog…
I was reminded about this in a behavioural finance webinar I attended this week (financial planning can be very exciting!). In the webinar, the speaker was explaining how it is generally a good idea to avoid changing funds or investments, once the correct portfolio has been established.
This reminded me of the original research, which was conducted on this, published in April 2000, just after the dot.com bubble burst. This research showed that there was a direct link between the amount you trade, and the return you achieved – the more you trade, the lower the return.
There are a few reasons why this is the case:
- The direct costs of trading. Since the research was carried out, there has been a significant reduction in these costs. Many investment platforms allow you to buy and sell your investments at no cost, so this is less important than it was, back in 2000.
- The indirect costs of trading. If you sell an investment and then buy another, there will be a period when you are “out of the market”, and your money will be held in cash, usually earning little or no interest. Investments produce better returns than cash most of the time, so, if you are “out of the market”, it is likely that you will be losing out (usually, this will only be a small amount and fluctuations in the market go down as well as up).
- Administration and tax costs. If you buy or sell an investment, you may have to ask somebody to work out whether there is a tax charge, and then pay the tax charge (unless your money is in a tax-exempt account, like an ISA or pension). My anecdotal experience suggests that the administration cost is usually higher than the amount of the tax payable.
Behavioural finance tells investors that the dog is more important than the fund manager. At times of volatility, it’s too easy to react quickly and make a mistake, when history tells us that inaction is often the best course of action.
If you are interested, the research is available for free on the web “Trading Is Hazardous to Your Wealth”, by Barber and Odean – published in the April 2000 edition of The Journal of Finance.
Philip Wise | email@example.com
Managing Director and Chartered Financial Planner