Ignore the Hype. Brian Perry
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Life at the Speed of Light
All around us, people seem busier these days. No one wants to wait for anything. Heck, between online shopping and delivery drones, we can get almost anything we want within 24 hours. For those unwilling to wait this long, 3D printing technology may soon allow instant home fabrication of a variety of goods.
And let me ask you a question about smartphones. The last time you waited in line for a movie, concert, Disneyland ride, or grocery store checkout, how many people in that line weren't multitasking on their phone, whether with social media, online shopping, or texting? My guess is not many. For better or for worse, our society has evolved to the point where patience is a very rare quality indeed.
This mentality extends into the financial arena: no one wants to invest their money and patiently wait for it to grow over the course of years or decades. No. We all want to trade, Baby, so let's light this candle and make a bundle fast.
How could we not, when the headlines are full of stories about Wall Street whiz kids who make millions a year and teenage tech entrepreneurs who make billions from their parent's garage? Never mind the bad old days, when wealth was generated over the course of decades through a combination of hard work, saving, and investing.
Since 1960, the average holding period for a stock has declined from eight years to eight months. Let me state unequivocally: an eight-year holding period constitutes an investment, whereas an eight-month time frame is a trade. And as I'll emphasize again and again throughout this book, there are fundamental differences between trading and investing.
The rapid pace at which many people turn over their portfolios is the antithesis of ignoring the hype and sticking with a long-term plan. But admittedly, the evolution of the financial markets has made it harder and harder to stick to a long-term approach, as evidenced by the decline in average holding period for a stock purchase.
Figure 1.1 shows some of the changes that have occurred in the economy, the financial markets, and the world. Many of these changes are net positives for you as an individual investor. But, as with many things in life, these changes represent a double-edged sword because the same developments that provide benefits also exacerbate the urge to give in to instinct and emotion and to do something.
Figure 1.1 How the World Has Changed for Individual Investors
SOURCE: Analysis by Brian Perry.
Lower Transaction Costs
The Change: From the time of its inception in 1792, the New York Stock Exchange set fixed commission levels. The result was that it was very expensive to trade stocks, particularly for individual investors. This was because the fixed commission represented a greater percentage of the total transaction proceeds on smaller trades. This meant that buying or selling stocks was expensive, which was bad. On the other hand, this expense caused people to carefully consider what they were doing prior to buying or selling, which was good.
However, on May 1, 1975, commissions were deregulated, and brokers were freed up to charge whatever fee they wanted. This event became known as May Day, and represented the start of a long-term downward spiral in transaction costs.
Discount brokerage firms, such as Charles Schwab, came into existence and began offering reduced transaction costs for trades. This meant that the commission an investor had to pay to buy or sell a stock began to decline. This trend toward shrinking transaction costs accelerated during the 1990s when the bid and ask prices on stocks began to be quoted in smaller and smaller increments. Previously, stock prices were quoted in increments of one-eighth of a point, whereas today they are quoted in pennies. This means that the bid/ask spread on stocks has shrunk dramatically, further reducing transaction costs.
Around the same time, the development of the Internet and the advent of online trading gave more and more investors the ability to execute their own trades, as opposed to calling a broker. Facilitating an online trade is more cost effective for brokerage firms; some of the cost savings are passed along to individual investors in the form of even lower commissions.
In 2019, this downward trend literally reached absolute zero. Major brokerage firms, such as Charles Schwab, TD Ameritrade, and Fidelity now offer clients the ability to buy and sell securities commission free.
A logical question, of course, is how companies stay in business without charging commissions. Generally speaking, the firms make money from the actual execution of the trade or they hope to entice investors to move money over to their firm. Then, while commissions remain zero, the firms hope to sell more lucrative products and services such as money management or cash management platforms. Thus, while the race to zero does negatively impact the profitability of these brokerage firms, it does not decimate their business models.
The Impact: In and of itself, the sharp decline in the cost of transacting in the financial markets is a good thing. Indeed, among the main beneficiaries are individual investors, who, as noted earlier, used to pay a disproportionately high commission when measured as a percentage of their transaction proceeds.
However, one of the unintended consequences of lower transaction costs is that it reduces one of the main impediments to rapid-fire trading. Previously, even if you were inclined to make a trade, you had to evaluate it in the context of the high commission you would pay. In the absence of this barrier, it's now easier to succumb to the desire to rapidly turn over the holdings in your portfolio.
Are you ready to have your mind blown? Fidelity Investments has literally millions of clients, so when they analyze client returns, they have a lot of data with which to work. In an effort to better understand investor behavior, Fidelity segmented their client base into various cohorts to determine what types of investors do best over time.
What Fidelity discovered is truly eye-opening, though perhaps not surprising. It turns out that the second-best-performing cohort were those investors who forgot that they have an account. Yes, people that didn't know they had an account outperformed those that knew they had an account.
Can you guess what the number-one-performing cohort of investors was?
Dead clients.
That's right, it turns out that one of the benefits of dying is that it becomes impossible to churn your account.
So, there you have it: if you want to increase your odds of achieving financial success, all you have to do is pass away.
Alternatively, if you want to achieve financial success without the adverse consequences of being dead, you can continue to read this book and follow the advice it gives.
Again, the more often you make changes to your portfolio, the less likely you are to meet your financial goals. So, while the explicit cost (the commission) to trade may have declined, the implicit cost (not meeting your financial goals) remains as high as ever.
Self-Directed Investing
The Change: One of the most important changes individuals have experienced over the past three decades has been the shift from defined benefit to defined contribution plans.
A defined benefit plan is commonly known as a pension. The way these operate is that you work for an employer for a number of years and hopefully they pay you for your work. They also promise you that, if you work for a sufficient period of time and leave in good standing, they will provide you with a future pension benefit. In other