Carbon’s fourth investment principle: active buying and selling adds significant cost and erodes value.

The hunt for Lord Sugar’s next business partner continues in the hit TV show The Apprentice. This year’s batch of ‘wannabe’ entrepreneurs were tasked with spotting the desirable items amongst a batch of curios and collectibles and then selling them at a Wimbledon car boot sale. Fund managers in the active investment world face a similar dilemma when deciding which stocks and shares to buy and sell.

When it comes to car boot sales and market stalls, trading is good for business. Goods can be purchased at wholesale rates then sold to customers at the retail price to earn a reliable profit. Sellers are normally keen to ‘turnover’ products quickly because stockpiling can involve storage costs and the risk that goods could expire if perishable or lose their value if they go out of fashion.

In contrast, most investments should be purchased with the expectation that they will reward investors for continuing to hold them, either by price appreciation or by receiving regular dividend or interest payments. At Carbon, we believe it makes sense to limit trading, also known as ‘turnover’, as much as possible because every trade incurs dealing costs. Research shows that keeping investment costs low is one of the most reliable ways to earn an above-average return.

Why do costs matter so much?

The figure above is based on an initial investment of £100,000 assuming a yearly return of 6.5% over a period of 30 years.

Simple arithmetic. When it comes to investing, the higher the costs, the smaller the amount left to pay a return to investors. As the above chart shows, a one percent difference in the yearly amount deducted in fees can make a huge difference to the return over the lifetime of an investment. Investment funds that are managed actively will often buy and sell regularly as managers try to exchange unwanted shares for the next ‘winners’ they feel are likely to outperform the market.

Such actively managed funds normally cost more than funds which simply buy and hold investments because trading and research costs will be higher. Managers seek to justify the increased fees by claiming to be able to beat the market through a combination of superior research and efficient implementation of their strategies. However, the vast weight of evidence disproves these claims, with the majority of actively managed investment funds underperforming the broad market they invest in over any meaningful time period (e.g. five years or longer).

What do we do at Carbon? Very simply, we follow our investment principles. These are designed to add value and avoid unnecessary costs. By selecting funds with low management fees and low turnover rates, we typically save clients 30% to 50% per year in investment costs. For further information, see No.3 in our ‘Six steps to successful investing’ (CONTROL YOUR COSTS), on our videos page.

This blog post was written by John Bell, financial planner at Carbon. You can view John’s profile here or contact him via email on john.bell@carbonfinancial.co.uk