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Is High Portfolio Turnover Bad?

by Mark Minervini

April 01, 2013



A common misconception about money management concerns portfolio turnover, the rate at which securities are bought and then sold. Many investors associate heavy trading in an account with high risk and runaway costs in the form of commissions and capital gains taxes.

 

Successful traders don't worry about how long they hold a position. Their main concerns boil down to being invested in the right stocks at the right time and tuning their overall cash-to-equity exposure correctly to take advantage of opportunity while mitigating risk.

Anyone who holds onto a suspicious or declining stock just for the sake of avoiding short-term capital gains taxes is missing the point of successful trading. Hold a declining stock long enough and you won't have to worry about any profits to pay taxes on! You'll end up paying the market in the form of a big, fat loss.

 

A skilled money manager buys or sells stocks based on the behavior and fundamentals of those stocks and even the condition of the overall general market. The level of portfolio turnover, be it high or low, is a byproduct of making the best possible trading decisions.

 

As long as there is evidence a stock has a high probability of producing future gains, I hold it. If a stock shows signs of topping, I sell it and take profits. If a stock falls below my pre-determined sell stop, I immediately sell it to avert a serious loss.

If high portfolio turnover is the result of taking small losses, then the high turnover may actually reduce risk. By selling off suspicious or declining stocks, a trader can reduce risk. Then the question becomes how to deploy the proceeds of the sale. Assuming the market still looks favorable and continues to produce attractive target stocks, the trader probably should reinvest the newly freed cash in another stock. If market prospects darken, the trader might sit tight, snug in the safe haven of cash, until conditions grow more opportune.

Left unmanaged, a basket of high growth stocks would pose great risk. Some of these high-flying stocks would follow parabolic arcs, and once they top and begin the downward leg of the curve, they drop like stones. There are very few stocks that one can salt away and forget under some "buy-and-hold" strategy.

Comparing turnover rates among short-term and long-term traders is like comparing the inventory turnover of a grocery store and a Ferrari dealership. A grocery store works on a very low profit margin. So a grocer must do high-volume sales in order to eke out in a big, cumulative profit. The Ferrari dealer makes far fewer sales, but at much higher margins. At the end of the year, both can produce a big profit.

Forget worrying about turnover. The only question should be; at the end of the day, does your style make money? Traders who impose a tight loss limit on their stocks will turn over their portfolios at a faster rate than managers who allow wider price leeway in stocks. They'll get stopped out of stocks more often.

Regardless of his level of trading volume, a skillful trader will act swiftly to sell off declining stocks before they can exact big losses or surrender large paper gains. Meanwhile, he will allow the winners in the account to come to fruition, offsetting the small losses with outsized gains.

The relevant course of action is to buy best merchandise at the most favorable time in terms of your trading style. Then set your sell parameters to determine how to secure profits and guard against losses. If you do that according to your plan and your portfolio shows only mediocre returns or worse losses, then you know you have a different problem; either you are setting your stop-loss too tight, your stock-selection criteria are flawed, or the general market is not favorable.

It's not hard to understand why so many people get hung up on the issue of turnover. One problem is account churning. Some unscrupulous brokers take advantage of unsophisticated clients by persuading them to sell and buy stocks just to generate commissions. On the other hand, many well-meaning but wrong-headed pundits recommend that mutual fund investors avoid funds with high portfolio turnover. These "experts" reason that the higher commission costs and capital gains taxes erode portfolio return.

At least one study suggests that high turnover funds, particularly growth-oriented funds, actually manage to eke out the best net performance among all mutual funds. I make this observation only to dispel the myth that high turnover is inherently bad.

Bottom line: Bad trading or poor risk/reward decisions hurts performance not portfolio turnover.



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