Here’s something that rarely comes up in investor education: If people buy and hold, they stand to gain at least 100 basis points per year. How is that possible?
Consider this. Gross returns depend on:
- the performance of the market as a whole
- the portfolio advisor’s skill
- investors’ own actions—essentially the size and timing of their purchases and sales of securities
A lot of effort is spent on Component 2. At the portfolio advisor’s level, this involves decisions on tactical asset allocation and security selection. At the investor level, the search for superior returns translates into efforts to identify skilled portfolio advisors and/or investment funds managed by skilled advisors.
It’s difficult to beat the market consistently. And it’s no easier for investors to identify skilful (as opposed to lucky) advisors than it is for advisors to generate consistent alpha.
Investors should focus on Component 3 rather than Component 2. Research has consistently shown that investors’ personal returns are lower than those of the funds in which they are invested. The shortfall, which amounts to 100 to 150 basis points per annum, is attributable to buying and selling at the wrong time.
Investors would be better off just holding on to their fund units. But since most of them do not even know their personal returns, they can’t quantify the impact of their decisions. (Thanks to CRM II, dealers and advisors will be required to provide personal rates of returns to their clients starting in 2016. The challenge will be to ensure that investors know how to interpret and use the new information.)
Investors’ final returns (what actually ends up in their pockets) depend on:
- the gross returns
- fees and expenses—among others, trading costs (including bid-ask spreads and market impact costs), management fees, operating expenses and sales loads
Investors are now better informed about the significance of fees and expenses, but they’re not as well-informed about the impact of taxes on non-registered accounts.
For example, every time investors sell a security at a profit, they trigger taxable capital gains and increase the amount of taxes they have to pay. And even though investors can postpone the payment of taxes on capital gains simply by holding on to their profitable investments, many don’t.
In the U.S., studies show frequent trading reduces the after-tax return of a portfolio by more than 50 basis points per annum. The same approach that boosts pre-tax returns also serves to reduce the tax burden.
Investors stand to add 150 to 200 basis points to their returns every year by doing nothing. And that additional return usually dwarfs potential alpha.
Low-hanging fruit can be reaped by anyone willing to adopt a disciplined approach to investing. This should be the central message of investor education.
André Fok Kam, CPA, CA, MBA is a consultant to the securities industry. He has advised securities regulators, fund managers, advisors and dealers. He is the author of From Conflict to Trust: How Mutual Funds Manage Conflicts of Interest (Toronto: Carswell, 2009).