Not turning the portfolio over enough is a drag on performance at the best of times. Companies go through their own cycle of value creation and destruction and the odds of outperformance over long (10-20 year) periods are poor (ca. 35%). Add to that some bad calls left to fester in the portfolio, plus the vagaries of economic cycles, and it is easy to see how relinquishing one’s freedom to position accordingly will have a severe impact of performance. It is desirable to keep a low but positive portfolio turnover in most years (say one or two buys and sells per quarter), if only to exit positions where the fundamental thesis has played out or been proven wrong, replace them with fresh opportunities, and cashing on the big winners to rebalance the portfolio.
At the other extreme, the negative effects of over-trading come both from fast increasing transaction costs (as a percentage of capital invested, which explains why reducing turnover by half typically only reduces expected gains by a quarter) and from ending up chasing price momentum (a speculative and inferior strategy since algorithmic traders will always have the edge). Over-trading increases costs and relinquishes the primary source of a human investor’s edge as:
- a compelling investment idea tends to play out over several quarters and even years
- a great portfolio consists of holdings delivering a wide range of returns in any given year: trying to only hold positions with positive returns only increases costs and risk
- a considerable amount of resources is already deployed to take advantage of the day-to-day market noise; a human investor’s time and money is better used elsewhere