Donna Block
SHAREWORLD
I remember my first year at University and my first class, Finance 101. The professor, a wizened old curmudgeon, told us that if we learned nothing else in his class, rule one about finance was that the stock market was a crap-shoot. “You place your bets and you take your chances.”
He added a caveat to this, and said that the risks of betting on Wall Street became somewhat diminished if the investor wasn’t looking for a quick thrill and held on to shares with a “long-term outlook”. But those were the days of the “Old Economy”.
Today we are entrenched in what economic fundis are calling the New Economy. All those old rules we learned in Finance 101 just don’t apply any more, and they certainly don’t appear to pertain to the share markets.
Betting on Wall Street has become faster and more furious today than at any time since the 1920s. According to a New York based investment research firm, in 1999 investors, on average, held stocks for just over eight months, well short of the two years that was typical a decade ago.
Among stock traded on the Nasdaq, the hottest shares last year, the average holding period was five months, down from roughly two years.
The itch to furiously trade has even infected the sober mutual fund world: investors are holding funds for less than four years on average. A decade ago, it was 11 years.
Heavy trading is becoming a major factor from big institutions that run mutual funds to individual investors who have flocked to online brokerage firms. Investors are being encouraged to trade more often as the commissions charged by online brokers get smaller and those charged by conventional brokers also shrink.
The Net is also instilling confidence in many investors as up-to-the-minute information is available round the clock, and investment chat rooms spur even the most conservative to grab for a piece of the pie.
Psychology plays a big role, too, with investors attempting to out trade their friends and always looking for the next big hit.
The figures confirm what some market analysts have suspected for some time: the rapid-fire trading mentality of a very small group of hyperactive investors known as day traders has altered the behaviour of large numbers of investors and is making inroads into the overall market.
The consequences are enormous, since studies show that investors who trade frequently get lower returns and heavy trading contributes to wide swings in the market. How frequently do shareholders trade?
Recent studies say that, on the New York Stock Exchange, the equivalent of 79% of all the shares listed there traded hands last year, up from 46% in 1990.
The Nasdaq is turning over its shares at more than three times the pace of any major industrialised market in the world. And while the data derived from the exchanges does not differentiate between industries, some of the Nasdaq stocks most popular with online investors trade furiously.
On the Nasdaq, shares of the 50 stocks that are the heaviest traded were held by investors for just three weeks, on average.
Analysts are concerned about this kind of trading frenzy and don’t really see it as investing but view it as real speculating. What many investors don’t realise is that this kind of frenetic trading can also lead to much lower returns since it’s not very efficient or cost effective.
According to academic studies it has been found that even in the bull market of the past decade, those investors who traded more frequently had lower returns than those trading infrequently.
But nevertheless, ever-increasing numbers of investors are succumbing to the trading rush and giving up potential profits in order to take part in the action.
The increasing transaction costs and taxes are not the only problems with excessive trading; the human factor is also problematic. Investors tend to sell their winners after a small profit and hang on to their losers. Psychologically, people feel good when they sell and realise their gains. By the same token they don’t want to take their losses, so they don’t and they sit much longer with the losing bet.
Besides reducing investors’ gains, the effects of rapid-fire trading are widespread. The practice has enriched both the brokerage firms that execute investors’ transactions and the governments that collect the taxes. Excessive trading also contributes to wide swings and increased volatility in specific shares and the overall market.
The long and steady rise in share prices over the past decade has fostered much of this kind of trading. Investors are attracted by increasing share prices and are trying their hand at trading for fun and profit.
But I’m sure my old professor, if he’s still around, is sticking to what he taught us in 101.