I just noticed that a stock of ours is about to do a 2-for-1 split in the upcoming week. My wife and I have owned 6 shares of this stock for over 15 years. Now, let me explain something here: we were awarded warrants in 1997 for 6 shares of this stock after an investment in the predecessor company called Westinghouse Air Brake had gone bad. There was a class action lawsuit and my wife and I ended up with warrants that entitled us to 6 shares of stock at a very low price. Our full service broker (this was in the days before we moved some of our money into a discount broker account) asked us what we wanted to do with the warrants–when I learned they would be worthless if we didn’t exercise them, we agreed to convert them into stock.
However, because we had only these 6 shares, and because a full service broker charges a lot more money per trade transaction than a discount broker, we just left those 6 shares to sit in our account all these past 15 years. At the time of the conversion on October 6, 1997, the price we got them at was around $15 as I recall, though the actual market value that day was about $23.50 a share. The name of Westinghouse Air Brake was changed to Wabtec as a reorganized company under the symbol WAB, a company that builds and services railroad locomotives and rail cars.
As of this date, June 7th, 2013, those same shares are now worth $111.03 apiece, and recently traded as high as $112.99. So, in 15 years, those 6 shares have appreciated by over 650% from our exercise price! If we had been smart enough to add more at the stock’s year 2000 low of $7.70, we would have realized gains of over 1,300%. At any rate, the 6 shares which were worth $141 in 1997 are now worth $666 some 15 years later.
So, what’s my point in talking about this today besides the fact that we have an example of “buy-and-hold dumb luck?” Well, think about this for a moment: we never sold those 6 shares because our broker’s commissions would have eaten away at most or all of our gains. So, I just sort of forgot it was there, although I thought about picking a time to add another 94 shares at a good buy-the-dips moment to make it a round lot of 100 shares–but as luck would have it, I never was paying much attention to it when I could have done so.
However, this points up a topic I often try to re-visit, and that is that traders who are constantly trading in and out of positions quickly have to keep the costs of trades in mind. Unless one is using a deep-discount broker, that trader is likely doing themselves more harm than good by trading positions quickly. The more one trades, the higher one’s friction costs.
What are friction costs? These are the transaction costs of a trade or investment. The friction costs include a small SEC fee and a broker’s commission fee for most retail traders. Consider that the average discount broker charges around $13 per trade to retail traders. That doesn’t sound like a lot of money, especially if a trader is making average trades in the thousands of dollars, but over time, those $13 trades can add up and eat away at your net profits (or worse, they can keep you from having net profits!).
Here’s a theoretical case example: suppose that Johnny Lightning is a trader with a $30,000 pot of money in a discount brokerage account over at XYZ Discount Brokerage. Now, this guy Johnny is pretty good at trading and he hones out an average 1% gross gain (before friction costs) on each trade over a week’s time which is equal to 52% annualized gains in a year’s time–this includes ALL winners and losers. Remember, that 1% average gains over each week becomes better than 50% gains over a year, not even thinking about the compounding of those gains (which would require him to increase his bets from $5,000 per trade).
Some trades, Johnny scores with 25% gains or more…but some others are losers, including a few real duds like losing all of his money in a few options trades gone bad. Still, despite such bad luck, Johnny still averages 1% gains per weekly trade and 52% gains for a year.
And let’s say that Johnny makes an average 10 trades a week (that’s both buying and selling–something that people forget is that for every purchase, there must eventually be a sale so that $13 average cost is really $26 on a round trip trade!)… and that his average invested capital per trade is $5,000.
So, Johnny makes five $5,000 trades per week and he closes them all out at the end of every week. His trade costs are $130 a week ($13 commission per trade x 10 per week) and he does this over a year’s time (52 weeks).
So, here’s the math:
Johnny’s gross gains:
- 5 positions per week x $5,000 per position= $25,000, so….
- $25,000 x 1%= $250 gains per week (before trading friction costs), so….
- $250 x 52 weeks= $13,000 profits (before trading costs).
Johnny’s trading costs:
- 10 trades (5 round trips) at $13 commission per trade, then….
- 10 x $13= $130 per week, then….
- $130 x 52 weeks= $6,760 in commissions paid for the year!
Johnny’s net gains:
- $13,000 – $6,760= $6,240 in net profits.
Actual net gain is cut in half. Divided over 52 weeks= $120. net gain per trade. The actual annualized net gain is cut by more than half!
So, though Johnny consistently beats the S&P benchmarks with 52% annual gross gains, his rather active trading costs cut his net gain by more than half! And let’s keep in mind that Johnny is a pretty sharp trader–imagine what the average trader or beginning trader must be doing if they trade as often as Johnny! (Don’t laugh! I know that there are many traders who trade more often than Johnny!)
So, I understand when people say that buy-and-hold strategy is dead….there are certainly not a lot of examples around where an investor can show that they have managed nice gains over the years by simply buying a stock and tucking it away for many years….
On the other hand, I think about my Wabtec investment and how big its gains have been over the years….and because the full service broker charges a lot more (like $200 per 100-share trade), this keeps me from making more than a few well-intentioned long term trades a year with him!
This also leads me to say that discount brokers have figured out a profitable formula for themselves, because their average cost per trade is lot less, they know that traders will trade more often with them for small gains. I recognize this myself….in some past years, I traded more than $4,000 in trading costs—and that with a deep discount broker charging well less than $13 a trade which is what the big name discount brokers like Schwab and TD Ameritade and E-Trade charge. Yet, on a trader’s portfolio of $100,000, that $4,000 trading charge represents a 4% annual friction cost charge! Why, even the poorest mutual funds don’t charge 4% trading costs per year!
The lesson here: maybe try to be more selective with longer term investments?….cut your trading costs down, and let things ride longer? Don’t sell on the first stochastics reversal!….in the long run, inflation drives up stock prices anyway, so even if you made a bad trade to begin with, your stock may come back if given a few months or years so long as you bought a high-quality best of breed type company! I know that sounds stupid to say trade less often on what is a trader’s website, but I say this for those of you less experienced in fast trading or those who don’t have the time to trade every day.
And as I have often said, I have never m
et a day-trader who traded his way to wealth (though I am sure the big hedge funds that start with big pots of money do day-trade, but they didn’t generate that wealth from scratch but rather with other people’s money!)….
And yet, the richest investors in the world remain the buy-n-hold types….does the name Warren Buffett ring a bell? His trading costs per transaction are probably much lower than that of the typical retail trader! …and he is enormously more wealthy than the rest of us!