Well, we've already covered three rules for investing in stocks, and to review those rules, rule number one is to avoid overlap. Rule number two is to employ high active share managers or a low-cost indexing strategy. However, mutual funds that attempt to imitate indexing strategies while having high turnover are best avoided. Rule number three is that concentrated stocks should be used. There is no need to have more than 50 or 40 holdings in any one classification, such as large-cap growth or large-cap blend. It allows the managers to research the stocks and identify the best, rather than having managers with no expertise in the particular category from which they are purchasing stocks on your behalf. Rule number four is to avoid any co-mingling. To do this, use separately managed accounts instead of ETFs or mutual funds. That brings us to rule number five.
Avoid Turnover - Rule #5
Rule number five is to abstain from turnover. It is a silent killer, especially in commingled fund products. Commingled fund products are mutual funds, while ETFs are closed-end funds. The goal is to eliminate unnecessary trading. Accordingly, as we consider rule number five and avoid turnover, we begin to think about the word trading. Here, a turnover is when a stock is sold and another stock purchased. To simplify the concept, let's consider pro sports. An athlete will retire, another one comes in, or they'll release the athlete, and then sign another one. The same principle applies to stocks. Thus, an annual portfolio turnover rate of 100% and the presence of 1,000 stocks in that particular mutual fund would indicate that all 1,000 stocks were sold during that particular year and we presume that additional stocks were purchased as well.
As we think about how to avoid turnover for rule number five, there is an article in US News and World Report titled "How Mutual Fund and Trading Cost Hurt Your Bottom Line" published March 4, 2013. The article states, "Stock mutual funds average 1.44% in transaction costs per year," and, then, in that article, it says,
"The SEC does not require mutual funds to make their trading cost known to investors.”
Therefore, transaction costs of 1.44% are a significant drag that accumulates over time.
It is your responsibility, and not someone else's, to ensure that you know the percentage of turnover in mutual funds and ETFs that you own and the specific stock strategy that your separate managed account manager has employed.
Additionally, forbes.com released an article on April 4 of 2011 titled, "The Real Cost of Owning a Mutual Fund” and in this particular article, it states that, "These costs can be difficult to determine, are not found in most prospectuses, and are not included in the expense ratio." It also mentions that "Disclosures do not provide investors with adequate information."
Avoiding turnover is a way to reduce the rate at which your money grows. It is important to understand the spread involved in a mutual fund selling a company. They go to a bank and offer a price. The SEC or Securities and Exchange Commission also receives a small profit on some of the trading fees that take place in these mutual funds, ETFs and closed-end funds. As a result, it is vital to understand that you cannot control whether there will be a buy or a sell. The only thing you have control of is choosing a stock-investing strategy that employs a low turnover and has a strong track record. I am confident that you can do that based on some of the research that's been done on this topic by Vanguard.
Vanguard found that for every 100% of annual portfolio turnover cost, there is roughly 1% in total transaction cost. If your portfolio has a turnover rate of 100%, it will cost you about 1% in transaction costs. This is the total amount of money, which is quite expensive. This means that your performance with 100% fund will be 1% lower per year if the 100% turnover continues than it would have been if those stocks had not been sold. The average active stock fund generates about 130% in turnover each year. The average mutual fund in ETF holds more than 650 securities and the average active stock fund has 437 holdings. Mutual fund managers are forced to trade daily. All of these are very important points to understand if you want the best stocks and make the most of investing in the US stock market. 650 securities is a large number of stocks. Consider a 130% turnover ratio. If you take 650, you will take 100%. That is 650 trades per annum. The average active stock fund has 437 holdings. That means that there are 568 buy and sell of individual stocks each year and we're not just talking about trades. Turnover refers to the complete sale of a stock, followed by the purchase of another.
As we consider the possible outcomes of turnover and how we can avoid them, we also want to remember that
turnover can result in increased commissions, trading spreads, soft dollar costs, and short-term capital gains.
These are costly consequences that occur when funds engage in high turnover or any turnover at all. Every trade will have a spread, and commissions. Stocks that have been held for less than one year will result in short-term capital gains. Remember, rule number five is to avoid turnover. We now move on to rule number six. It is very important that drawdowns are reduced and long-term returns increased. Big losses are worse than big gains. For many years, this has been my mantra, and I believe that is why God has instructed us to diversify. He doesn't want to see us lose what He has given us. He also doesn't want to keep us emotionally bound in how we perform with our money when He sent us here to serve Him and others.
Reducing Downside Risk - Rule #6
As we examine our sixth rule of protecting the downside, it is important to identify managers that have shown ideal downside capture metrics, and have done so historically. Studies have been done to determine how much downside you can capture over a long period. They've also looked at portfolio performance based on consistency versus big losses with the same average return. They found the same relative return even with a smoother portfolio. However, if the relative and absolute returns differ, then there is a difference in consistency. Thus, as we glance at the 90 years from 1925 to 2014, we see that a portfolio that captured 89% of its upside and 89% of its downside of the stock market outperformed a portfolio that captured 100% of both upside and downside. This would basically mean that the stock market is what it captures.
If we created a portfolio of $10,000 in 1925 and it only captured 89% of the upside and 89% of the downside of the stock market, then the position would have been worth 53.9 million by the end of 2015, whereas the portfolio that only captured 89%, both on the upside and the downside, would have been worth 62.6 million. This is a difference of 16% over a period of 90 years, which is still quite significant. This suggests there would have likely been a significant difference even after 20 or 10 years. Therefore, limiting drawdowns is crucial and something that I have always emphasized. If your $100 is reduced by 50%, it will give you $50. If this same $50 increases by 50% instantly, you will only have $75. Thus, it's more difficult to recover from a large loss than with gains, and you also can't diversify your asset classes.
It is essential to have stock managers with a track record of being able to limit downside risk when investing in stocks. Although 89% implies participation in most stock movements, it's still less than 100% which will help preserve your capital. Furthermore, limiting your downside is always important during a market crash, or an enormous market correction. It will affect the amount of money that you have at end of time more than the big gains.
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