The Best of Business Week Online: Investing
Don't Touch That Keyboard
Want to waste time and money? Do lots of online stock trades in long-term accounts such as 401(k)s
Thanks to the Internet, it has never been cheaper for individual investors to trade stocks. At the same time, average quarterly trading volume on the Big Board has more than doubled over the past three years. Is it just more people drawn to Wall Street because of a bull market? Or is the steep decline in commission costs encouraging individuals to trade more than ever?
A recent economic study strongly suggests the latter. The results of the research paper, "Does the Internet Increase Trading? Evidence from Investor Behavior in 401(k) Plans," by economists James J. Choi, David Laibson, and Andrew Metrick, argue that the cheapness of trading on the Web does add to the trading frenzy. Now, increasing trading is not bad from an economic perspective--far from it. The authors point out that the easier it is for investors to buy and sell stocks, the better the financial markets allocate capital away from unprofitable activities into more promising opportunities.TURNOVER. But there's a disturbing side to this, too. The surge in trading they highlight takes place in retirement-savings plans, an investment vehicle that is designed to reward patience and long-term thinking rather than wheeling and dealing for a quick buck. (You can get their article, Working Paper No. 7878, at www.nber.org.)
The economists' evidence is striking. They look at the impact of Web-based trading by gathering data from two corporate 401(k) plans, each with about 100,000 participants. Both companies began allowing their employees to trade 401(k) stocks through their corporate Web sites in August, 1998. After adjusting the data and comparing trading growth patterns with a sample of corporate retirement-savings plans without a Web channel, the research team calculates that trading activity nearly doubled with online access. Daily turnover, which is the portion of balances traded, rose more than 50%. They also find that younger employees, especially men, are among the most aggressive buyers and sellers among plan participants.
The hot trend today in retirement savings plans such as 401(k)s, is to offer participants an online trading option. Although technology creates the opportunity to add Web-based trading to a plan's menu of choices, industry experts say senior management is the driving force behind the added benefit. It won't be long before nearly all large-company defined-contribution pension plans include online trading, much as the ability to change mutual-fund asset allocation over the phone became standard a decade or so ago.
Yet there's no evidence suggesting that all this trading activity in retirement accounts pays off for participants, and there's abundant evidence that a disciplined, long-term approach with minimal trading increases the odds that investors will reach their long-run financial goals. For instance, economists Brad Barber and Terrance Odean at the University of California at Davis looked into the stock-trading behavior and investment performance of more than 1,600 investors who switched from phone-based to online trading from 1992 to 1995. Big mistake. Individuals who made the switch traded more actively and more speculatively than before, and their returns went from beating the market by an average of 2% to trailing it by more than 3% annually.
It's tough to beat the market, whether trading online or through a broker. Investing is one of the most competitive businesses in the world. Markets move at quicksilver speed in a global economy linked by computers, satellites, and fiber-optic cables. It's difficult to gain an investment edge regularly on everyone else.
How many investors in a 401(k) plan possess real discipline and market smarts when it comes to picking stocks or mutual funds? Not many. Individuals who trade stocks by the hour or the week or those who move in and out of mutual funds several times a month or quarter are wasting their time and money.By Christopher Farrell; Farrell Is Contributing Economics Editor for Business Week. Read His "Sound Money" Commentaries Each Week at Business Week Online.