I frequently mention that, when selecting mutual funds, it’s generally advantageous to look for funds with low turnover.

What I’ve noticed from comments on the blog and emails I’ve received is that some investors seem to miss the fact that the same thing applies to our own portfolios. Generally speaking, increased turnover is a bad thing.

Increased Costs

Most obviously, increased turnover leads to increased transaction costs:

• If you purchase individual stocks or bonds, each transaction comes with a cost. Even if you’re using a discount brokerage firm, those $7 trades begin to add up.
• If you jump between funds, there may be a transaction cost (depending upon which funds you use and how quickly you sell them after buying them).
• If you’re investing in a taxable account, turnover means incurring capital gains taxes earlier, which is harmful to returns.

Increased Risk

Less obviously, increased turnover in your portfolio creates a cost in terms of extra risk you take on.

For example, there’s a high probability that if you hold a stock-based mutual fund for a long enough period of time, you’ll enjoy a positive rate of return. However, if you constantly jump back and forth between various mutual funds, it’s no longer such a sure thing.

Increased risk and increased costs, without an increase in expected return. What’s not to love?

The alternative: “Don’t just do something, sit there!”

According to Morningstar, the average annual turnover within domestic stock funds is 104%. In other words, on average, domestic equity funds hold a stock for just 351 days before selling it.

Of course, such high turnover has a negative impact on returns in that it substantially increases costs. But even leaving that issue aside for a moment, doesn’t this level of turnover strike anyone else as a bit frightening?

I’m not a stock picker, and I never have been. Nor do I want to pay anyone to pick stocks for me. That said, if I was forced to choose between:

1. A fund manager engaging in the Warren Buffett/Ben Graham “my-favorite-holding-period-is-forever”-type of investing, or
2. A fund manager who holds stocks for less than one year before selling…

…I’d have very little hesitation about going with option #1.

I’m not here to say that it’s impossible to be a successful short-term trader. I am, however, concerned that many fund investors think they’re using a long-term buy & hold strategy, when in reality, all they’re doing is paying somebody to engage in short-term stock picking with their money.

I’m not kidding or exaggerating when I suggest that people ignore what the market does from day-to-day, month-to-month, or quarter-to-quarter.

As far as I’m concerned, two glances at my portfolio each year is plenty. Now, before you decide I’m completely crazy, let me remind you that I’m not alone. Some respected investors hold similar opinions:

“Try and avoid the worst hazards of behavioral investing. Follow the basic rule that I follow: Don’t peek. Don’t look at your account. Throw the 401k statement in the trash when it comes.” -John Bogle in an interview with Steve Perlstein.

“The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored.” -Benjamin Graham in The Intelligent Investor

Why not check more often?

I’ve always been of the opinion that information is worthless unless it’s actionable. So as far as I can tell, there’s absolutely no good reason to check your account value aside from during your scheduled rebalancing & goal assessment checkups. All that will come from extra checking is extra worry (and perhaps, therefore, a mistake you’ll regret later on).

Part of the reason I don’t check more frequently is that the bulk of our retirement accounts are invested in a target retirement fund (via Vanguard) that keeps our asset allocation fairly close to where we want it.

However, from what I’ve read, there’s no predictable benefit from rebalancing more frequently than once per year anyway. So even if you do your rebalancing manually, there’s little reason to check your portfolio more than a couple times each year.

Staying Oblivious

Some people might find it difficult to avoid peeking at their account balances given the constant flow of news about the stock market. Here’s how I do it:

• I don’t read the newspaper.
• I don’t listen to the radio.
• I don’t watch TV.

(Though in all honesty, my reasons for removing those activities from my life has more to do with thinking that they’re a waste of time than it has to do with investing.)

What do you think?

How often do you check your own portfolio? Do you think you’d benefit from cutting back on that frequency? (And do you think you’d be able to?)

I recently saw an interview with Suze Orman discussing passive, index investing. In it, she provides us with the following insight:

“I’m not sure you can buy and hold that way and just forget about everything as if everything will be OK.”

If you look around the realm of personal finance (online or offline), you’ll be inundated with similar messages. Two quotes from recent emails I’ve received appear to be perfect examples:

“Over the last decade, we’ve learned that passive investing doesn’t always work.”

“Passive investing only works during bull markets.”

In other words, as Jason Zweig recently stated, “today, it has become trendy to declare that ‘buy and hold is dead.’”

Got a better idea?

Will buy & hold index investing ensure that you reach your goals? That depends to some extent on what your goals are, but the honest truth is that no, it probably can’t guarantee that you’ll reach them.

A more meaningful question, though, is whether there is a better alternative. Can we hope to do better by using some other strategy?

To be able to earn a return better than that provided by a long-term, buy & hold indexing strategy, we have to either:

• get lucky, or
• outsmart the market in some way

Outsmarting the market

All the various methods for attempting to outsmart the market can be broken down into two broad categories:

1. picking stocks (or other individual securities), or
2. timing the market

Picking Stocks

My rule of thumb before investing in an individual stock is to ask myself whether I have any information about the company that would not already be known to somebody whose full time job it is to stay informed about the industry the company is in. If I can’t answer in the affirmative, I don’t buy the stock.

(To date, I’ve never answered in the affirmative, though I don’t entirely rule out the possibility of it happening someday. )

Timing the Market

The difficulty of predicting short-term market movements is analogous to that of picking individual securities: Short-term market movements are the result of new information being released. To be able to predict the market’s movements, you need to know something that the rest of the market doesn’t yet know.

It’s not perfect…

Long-term, buy & hold, index investing is far from a perfect strategy. But a declaration that “buy & hold is dead” is worthless unless coupled with a strategy for doing better.

And let’s not forget that every effort we make to “do better” puts us further behind as a group.

In the last few weeks, a handful of people have asked to see a greater discussion of the drawbacks to passive investing. I’ve been thinking about it a lot. So here we go…

1. It’s boring.
2. There’s precisely zero chance that you’ll get rich overnight.
3. It’s difficult. (Not the mechanics of it–those are quite simple. The hard part is sticking it out through a down market.)

From my perspective, that about covers it. Anybody have anything they want to add?

Over the last several weeks I’ve been mulling over exactly how low the market would have to go before I became uncomfortable buying stocks.  The more I thought about it, the more sure I became that there’s no point at which I’d stop buying stocks.

If the market dropped to 1/4 its current price (yeah, that’d make an 85% one-year decline), I’d still be buying stocks. In fact, I’d still be buying them at that price even if I knew they had no prospects for appreciating in value.

Why?

Dividend Yield.

As I write this, the dividend yield on a share of an S&P 500 index fund is approximately 3%. (For reference, dividend yield is calculated as dividends paid per share divided by the current price per share.) As the price of our stock market declines, the dividend yield goes up. That’s just how the math works.

And that is why I plan to continue buying equities regardless of how low the market goes. For example, if the market really did fall to 1/4 of it’s current price, the dividend yield would be greater than 12%. That’s absurdly high. High enough that it would provide an excellent return even without any price appreciation. Of course though…

None of this will happen

…precisely because of the dividend yield. As dividend yields rise (due to falling share prices), shares begin to look more and more attractive (and not just to crazy equity zealots like me, but to mutual fund managers as well).

This is a part of the reason that bear markets eventually bottom out and begin to turn upward. In effect, there’s somewhat of a floor below which stock prices tend not to fall.

So again, we come to the conclusion that the the only scenario in which stocks would not be an excellent long-term investment is one in which corporate earnings (and thus dividend payments) decline precipitously from where they are now. Call me crazy, but I just don’t see that happening (at least, not in the magnitude that would be required in order to make stocks a poor long-term investment).