Why overtrading can kill your returns

The world of the private investor has changed radically over the last few years. All sorts of things have become possible.

These days I often meet people who have live stock market indices and prices displayed on their iPhone or BlackBerry. With breathless pride they show me some share that was last seen at 10p is now trading at 12p! Maybe at this sudden stroke of good fortune they are tempted to sell, and thanks to more wonders of digital communication they can do so instantly.

No doubt this convinces them that they are in control of their financial destiny. Perhaps also they feel just a little macho, finally able to take their place alongside testosterone-fuelled City traders. But if anybody benefits from this instant activity, I reckon that it is only the communications provider and the broker who gets the dealing commission.

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The question is are these advances actually doing private investors any good?

I worry that they are not.

How investors got lost in a world of spin

Amongst all the chaos of the financial world one feature that strikes me hard is the extraordinary increase in trading activity. According to the London Stock Exchange, the average holding period for a share back in 1966 was eight years. It has fallen steadily ever since and is now below six months.

The reasons are not hard to discern. The narrowing of bid/offer spreads, at least amongst the bigger stocks, and lower dealing commissions have reduced what used to be a disincentive. Fund managers, driven by quarterly performance considerations, have a necessarily short term view - although this is nothing new. What is relatively recent are the computer-generated trading strategies, employed by hedge fund managers, designed to take advantage of slim arbitrage opportunities.

Throughout the media there seems to be fixation on share prices, while very little attention is paid to the thing that ultimately determines share prices: the performance of individual companies and the various techniques for their valuation.

Before the internet arrived the nearest thing we had to a central source of information was the Extel information service, filed cards upon which the essential facts and figures of a company's recent history were crammed in small type. If you were lucky these might have been available at your local reference library, along with a few other dry studies of industrial trends.

For most investors, though, research began with a company's annual report and continued perhaps with a chat to the directors at the AGM, with background reading provided by the national newspapers and financial magazines. The keenest investor would patiently plot his own share price charts on sheets of file paper.

If he then wanted to deal he would have to visit the bank, or else call his stockbroker. By today's standards this sounds thoroughly inefficient, but it did at least give the investor a chance to think and reflect.

Today we are simply bombarded with information. Watch the CNN financial channel with prices sliding relentlessly across the screen and talking heads giving a series of impromptu soundbites, your head will spin and you will learn nothing of value.

An essential toolkit for investing

One of the better things that I ever did was to take the exams necessary to become a member of the London Stock Exchange. There were four papers Tax, Techniques of Investment, Stock Exchange Practice, and Interpretation of Company Report and Accounts. The last was taught by the wonderful Geoffrey Holmes who with Alan Sugden wrote a book of the same name that you can still buy today.

In that class we were taught to look for rising sales not inflated by acquisitions, of course; for steady profit margins; for positive cash flow; for the ability to pay a dividend; for all the signs that a business was still prospering or perhaps was running out of steam.

It was all basic stuff, but to my mind an absolutely essential toolkit for anybody contemplating buying a share. It still applies today.

If you analyse a company properly before buying its shares, you will be more confident of holding it. That will allow the wealth-creating engine of the company to multiply the value of your investment. Hold a share for just a few weeks and that simply cannot happen. Over-trading will kill your investment return. But in today's world I see that far too often.

This article is taken from Tom Bulford's free twice-weekly small-cap investment email The Penny Sleuth. Sign up to The Penny Sleuth here.

Information in Penny Sleuth is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. Penny Sleuth is an unregulated product published by MoneyWeek Ltd.