All the talk about high frequency trading reinforces the fact that securities are now trading hands at an ever expanding rate. From The Economist we learn that holding period for stocks has declined noticeably over time.
It is true that professional investors tend to hang on to their shares for a lot less time than they used to. Figures from Société Générale show that the average holding period of a stock on the New York Stock Exchange fell from ten years in the 1940s to nine months by last year.
Is this at all surprising? The cost of trading has declined as well over this time period, accelerating with the end of fixed commissions in 1975. As automation has increased the cost of trading both in actual commissions paid and market impact has declined.
Portfolio managers trade for any number of reasons, some good, some bad. Data comes out that change the outlook for a security necessitating a portfolio change. Inflows (or outflows) require a re-balancing of the portfolio. Or it could simply be the case that trading is fun. As the costs of trading have declined it has also removed some of the inhibitions from trading.
There is a striking parallel between the reduction in trading costs and the reduction in our food costs. Many blame the rising incidence of obesity in America on simple economics. The cost of our food supply (on a per calorie basis) has declined while our need to burn calories has also declined. This combination not surprisingly leads to predictable results, obesity.
In addition, the form in which those calories increasingly come is in the most enticing form: fat, sugar, salt. All of which our primitive brains are pre-programmed to enjoy. Is it any wonder that we as a society are getting heavier? Societal norms are now making it easier for people to become and remain overweight, much to the detriment of our collective health.
The parallels between commission and calories are striking. Unfortunately both lead to adverse outcomes. In the first case overtrading and the second obesity. Lower trading costs, both explicit and implicit, and a removal of an strictures against trading have cleared the way to higher portfolio turnover. One could argue that this has lead to a short term focus and overtrading.
Just as there is a brief high when we open that bag of french fries or can of soda there is a similar buzz from trading. Unfortunately for the investor there is a cost to that fleeting feeling on the part of the portfolio manager: underperformance. The highest costs funds tend to be those that trade the most, and subsequently those funds with the highest expense ratios had the lowest returns. (See John Bogle on the hidden costs of high portfolio turnover.)
In this day and age it takes some degree of discipline to keep from overindulging or overtrading. A focus on the longer term can help alleviate the lure of that short term high. There are real benefits to cheaper calories and commissions, but their true costs may be much higher than advertised. In short, just because something is cheap does not mean it cannot have a high cost.
Update (August 8, 2009): We subsequently noticed a couple of blog posts that make some similar points.
Brett Steenbarger at TraderFeed asks what would happen if you could only make two trades a day? In short, “You would have to be very selective in your choice of trades. That means you would have to be extremely patient and disciplined.”
Justin Fox at Curious Capitalist on how the post-1975 the financial system looks: “It’s a vastly more competitive and less calcified set-up than what went before. But I’m not so sure it’s all that much less expensive, and it’s certainly more unstable.”