How a high portfolio turnover rate eats into your long-term profits

Every time you buy or sell a stock, you face three costs that increase your portfolio turnover rater

Investors often wonder how often they should sell investments they own and buy new ones. Our answer: as rarely as possible. That’s because a high portfolio turnover rate cuts into your profit.

Every time you buy and sell a stock you face three costs:

Brokerage commissions. Every transaction involves brokerage commissions or similar costs, even if these costs are hidden or built into the price you pay or receive.

Losses to the bid-ask spread. If you want to carry out a transaction right away, you have to accept the highest available “bid”, or pay the lowest “offer”. You can enter your own bid or offer. But this means you have to wait for another investor who is willing to do business at your price. Meanwhile, prices could move against you.

Taxes. If you sell at a profit in your taxable account (outside your RRSP), you usually have to pay capital gains taxes.


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Successful investing means portfolio turnover of 25% or less in a year

Here is how you measure your portfolio turnover rate. First, add up the value of all investments you bought during the year, and all investments you sold. Next, add the beginning and year-end values of your investment portfolio. Divide the first number by the second.

Example: You sold shares and exchange-traded funds worth $20,000. You held on to $3,000 to pay capital-gains taxes, and bought shares and ETFs worth $17,000. Total, $37,000.

Your portfolio is worth $50,000 at the beginning of the year and $57,000 at year’s end, for a total of $107,000.

The next step is to divide $37,000 by $107,000. The result is 34.6%. That means that you replaced an average of 34.6% of your portfolio during the year. That’s on the high side. Many successful investors have portfolio turnover of 25% a year or less.

Our investment advice: Decrease your portfolio turnover rate and raise your profit. It pays to seek out stocks that you might want to hold on to indefinitely. You’ll change your mind on some of them, of course. But you’ll hold others for decades, and these will give you your biggest profits.

You may also want to the take a bottom-up approach to your investing strategy. This investment strategy focuses on understanding what’s going on, rather than trying to predict what happens next. You could call this descriptive finance. You delve into earnings, dividends, sales, balance sheet structure, competitive advantages and so on. Bottom-up investors tend to make fewer big mistakes. This lets their gains accumulate. This also leads to longer holding periods, which provide greater tax deferral and lower brokerage costs. Lower brokerage costs as helps you lower your portfolio turnover rate. Making you a happier and wealthier investor in the long-term

Do you tend to buy and hold stocks for a long period of time? Or do you keep some stocks for a shorter period and sell them after a price surge, or a fall in price? Do the costs of trading figure into your decision as to whether to buy, sell or hold a stock? Let us know what you think.

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