Style Drifter

Stock Pickers: Taxes, Style Drifting, and Coin Flipping

Disclaimer: This article contains information that was factual and accurate as of the original published date listed on the article. Investors may find some or all of the content of this article beneficial but should be aware that some or all of the information may no longer be accurate. The information and/or data in this article should be verified prior to relying on it when making investment decisions. If you have any questions regarding the information contained in this article please call IFA at 888-643-3133.

Style Drifter

What kinds of traits define a stock picker? Here is a short list attributes that are very common among those who like to look for the needle in the haystack:

Taxes

Stock pickers manage their portfolios as if taxes do not matter. The average active manager has approximately a 100% turnover rate per year, while index funds range from 5% to 35%. The cost of turnover is detrimental to the overall performance of the portfolio.

There is a substantial incentive for investors to hold their stocks for a year or more. For stock sales with holding periods of less than one year, the gain is treated as ordinary income and is subject to the full federal and state tax rate.

Depending on the tax bracket and state of residence, this could be 39.6% for federal taxes and 11% for state taxes and can have a dramatic impact on actual returns. For holding periods of one year or more, the tax rate is reduced to the long-term capital gains rate of 15%.

Style Drifting

One of the most difficult problems in confirming stock pickers’ skill is that they are constantly changing the criteria, ownership rules or style of their investments. Since their style is constantly changing, it is very difficult to track and compare them to the proper index. In fact, one study found that 40% of mutual funds are invested outside of their stated styles. This will alter their performance and result in different risk and return characteristics, which is sort of like changing the number of dice in the dice roll example. In fact, every portfolio that differs from the stated benchmark or style will result in a different return. Since these portfolios that have drifted from a benchmark have no long-term characteristics, investors have no idea what to expect from the manager’s newly created style. In the absence of expectations, an investor becomes a speculator, and the expected return of speculation is zero. Style drifters are further discussed in Step 6.

Coin Flipping

The attempt to predict the outcome of a coin toss is a futile endeavor. Unless the coin is rigged, the only way to make a correct prediction is to guess blindly. Unfortunately, it is with the same disregard for investors’ financial health that the financial institutions and media perpetuate the false idea that some people have a gift or method for predicting future stock price gyrations.

In a study by Walter Good and Roy Hermansen, a hypothetical coin flipping experiment was compared to mutual fund manager performance. Three-hundred college students were asked to guess the outcome of 10 coin tosses. Their guesses were tabulated and charted. The performances of 300 mutual fund managers were then tabulated for 10 years (1987 to 1996) from Morningstar® Principia®. See Figure 3-7.

The number of years that the mutual fund managers were rated in the top 50% of fund managers was then counted and compared to the ability of college students to correctly guess the outcome of the flip of a coin. The results were nearly identical.

An interesting point was raised by a hypothetical nationwide coin toss. In this example proposed by Warren Buffett, 225 million Americans are given one silver dollar and expected to flip it once per day, with heads winning and tails losing. After 25 consecutive days, the statistical result would be comparable to six people flipping heads for 25 days in a row. These people would be regarded as geniuses for being so masterful at flipping coins. This is nonsense, of course, but it would do well for investors to see mutual fund managers as the six masterful coin flippers rather than geniuses, gurus or all-star analysts.

Figure 3-7

In a study by Walter Good and Roy Hermansen, 300 college students' guesses of the outcome of ten coin tosses were simulated. The performances of 300 mutual fund managers were tabulated for ten years (1987-1996) from the Morningstar Principia database. The number of years that they were rated in the top fifty percent of fund managers were then counted and compared to the simulated ability of college students to correctly guess the outcome of the flip of a coin.