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Investing: How following top performing stocks can guarantee you a loss

Plonkee wrote a few days ago about feeling uncomfortable giving investment advice. I know I certainly wouldn’t want to give more advice than “I think indexing is a good way to go for long-term gains.” I’d suggest they read the Lazy Person’s Guide to Investing (affiliate link) or at least Trent’s review of it at The Simple Dollar. There’s some very simple portfolios which look like they’re perform well.

What struck me most about plonkee’s post, however, was this:

At the moment she’s letting (or planning to let) a friend do it – I’m not sure how this works in practice. …

The reason that she’s letting this friend choose her investments is that the friend is so passionate about her funds, checking their performance regularly and making sure they’re in the top few performers.

It makes some sense. You’d want someone involved to make sure your investments are in the best shape possible, right?

Well, here’s a couple big caveats.

  • First, you’re almost guaranteed a loss in transaction fees.

What do you want to guess than this hot trader isn’t making all his trades for free. Suppose that he’s getting them cheap at $8 per trade. And suppose that he rebalances the portfolio once a month (I’m not sure what “checking regularly” is, so this is just a hypothetical situation). Perhaps he needs to change about 5 per month to make sure the portfolio has the top performers. That’s $40 per month.

Which is $480 per year. So now the stocks don’t just have to outperform the other

  • Second, what about gains?

How are gains taxed for this portfolio? If it’s in certain retirement accounts, then you don’t really have to worry about it. Otherwise–she may lose more money through gains taxing than she gains by changing stocks.

I’m not an expert on how all this works. Especially since she’s British and I know less about their tax code. But it’s something to consider. (If you’re American, consider visiting Don’t Mess With Taxes and running a search for “capital gains.” The search box is currently in the right sidebar if you scroll down a bit.)

  • Third, what if he sucks?

Seriously–how many people beat the market? Maybe Warren Buffet–but not Joe Investor. By investing in an index fund, plonkee’s friend would at least be going with the market.

Not just that, but indexing means that she should constantly be having high performing stocks. That’s essentially what the S&P 500 is, right? So not just a friend checking in a few times a month/year/whatever to make their own judgment calls–her investment will be following the market every day.

  • Bonus: most index funds have very small managing fees–ones that will eat up a lot less money than her friend’s trading will cost her.

Like plonkee, I wouldn’t want to manage anyone’s money. That’s too much responsibility for me right now. But I would recommend against her current plan and for looking into index funds.

(Note, plonkee’s friend is British, I assume, so talking in pounds would be more relevant. However, I’m more comfortable with USD, so I’m talking about that.)

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plonkee December 9, 2007 at 4:19 pm

You are so right (as usual).

We are basically talking about retirement funds here, so capital gains tax isn’t going to be relevant – and if it was there’s an £8,500 tax-free allowance anyway.

I’m worried that the investments will suck, and someone who doesn’t know what they’re doing will lose money they can ill afford to. Even the most likely scenario is that they’ll lose through fees and the like.

mrsmicah December 9, 2007 at 4:26 pm

Indeed. Retirement is not a get-rich-quick scheme. If people have a bit of extra cash they’d like to see expand, then perhaps such investing is worth a shot. But retirement is a serious matter—it also means you can take it slow, since you won’t need big payoffs next year, just lots of decent ones for 20-40 years.

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