“One who sees inaction in action, and action in inaction, has understanding among men, disciplined in all he performs. ”

—Bhagavad-Gita, Chapter 4, Verse 18

As you may have noticed, financial markets have been uncertain of late. The conventional response is to take some sort of action to better position the portfolio for the current environment. This might include trying to move in and out of different asset classes, trying to choose an investment manager who can pick the best stocks, or simply getting out of the markets altogether. But some results indicate that the best course of action is to take as little action as possible. Doing nothing in the face of changing markets may seem counterintuitive to most people. Nevertheless, when it comes to investing, inaction is often the best course of action. This is not to say that it is best to ignore portfolios entirely. Rather, the correct approach is to be highly disciplined and selective when making any and all changes to a portfolio, instead of reacting emotionally to short-term market fluctuations.

There is ample evidence to suggest high levels of portfolio activity are unlikely to improve long-term performance. Take Jeremy Grantham, a legendary investor who runs a multibillion dollar institutional investment firm. Grantham also manages his sister’s retirement account, but not through his firm. He estimates that he trades his sister’s account once or twice per year and produces returns that are 1–2 percentage points higher than the performance of his company’s funds. Or, look at the ING Corporate Leaders Trust, which has outperformed the overall stock market over the past 10 years with no investment manager and a group of stocks descended from a portfolio set up in 1935 and not traded since. If you really need convincing, look to the Oracle of Omaha himself. Warren Buffett describes his investment time horizon for a stock as “somewhere between 10 years and forever.” A more academic assessment of the costs of high activity comes from researchers Geoffrey Friesen of the University of Nebraska–Lincoln and Travis Sapp of Iowa State University. They calculated that between 1991 and 2004, “market timing” decisions reduced equity fund investor returns by 1.56% annually [1]. In theory, taking action and making changes to your portfolio could be effective. It is certainly human nature to want to try. However, even smart investors are not particularly good at it, and the best investors avoid it almost entirely.

Two other big reasons for inaction (better known to finance geeks as “low turnover”) in a portfolio are taxes and costs. Taxes are generally either ignored or placed on the back burner by most investment managers, but they can be a huge drag on investment returns if not managed properly. Any time you sell an investment at a profit, you have to pay capital gains taxes (15% for “long-term” gains and usually a higher ordinary income tax rate for “short-term” gains). So, frequent trading can significantly weigh down your returns after taxes are figured into the equation. In an influential paper some years ago, noted finance researchers Robert Arnott and Robert Jeffrey pointed out that very few investment managers actually outperform by enough to cover their capital gains taxes [1]. In other words, their clients would have been better off, on an after-tax basis, if they hadn’t traded at all. Therefore, it is best to avoid high turnover in your portfolio in order to avoid giving undue money to Uncle Sam.

The exception to this low-turnover rule is realizing tax losses, which Arnott and Jeffrey point out “are like cash in the bank.” This practice involves selling investments that have declined in value and immediately purchasing similar replacements so that your portfolio allocation does not change substantially. In this situation, you get a tax benefit from the capital loss you realized, which should help improve your investment results on an after-tax basis.

Higher investment costs are often a result of high portfolio turnover. Generally, investment managers who trade a lot are able to charge higher fees for all their activity, even if that activity does not produce better results. Additionally, there are higher costs embedded in the trading process. Brokerage commissions, the bid–ask spread, and market impact costs — all serve to erode the returns of more active traders. Even if investment managers can improve returns marginally by trading aggressively, the evidence suggests they cannot improve returns enough to overcome the costs of their trades. Morningstar, the mutual fund research firm, has conducted studies on the impact of investment costs and concluded that the strongest determinant of future investment returns for mutual funds is the management fee. Lower-cost funds tend to outperform higher-cost funds on average, which is fairly intuitive.

Ultimately, turmoil in the markets can be difficult to endure, especially when the preferred strategy is to sit back and wait. However, my goal is to focus on time-tested strategies: maintain an appropriate long-term asset allocation plan, keep turnover low to minimize taxes, and invest in a low-cost manner. As always, we will also rebalance between investments when necessary to keep your risk profile in line with what is appropriate. Rebalancing is one form of turnover that we believe is necessary. These are all things that, unlike the performance of capital markets, are within our control and have historically proven to be the best strategies available for building and maintaining long-term wealth.

If you liked this post, dont forget to subscribe to Inside Investing via Email or RSS.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Photo credit: Istockphoto/Jobalou