Investors Will Have to Learn to Trade! January 21, 2011.

The statistics are eye-opening. The average holding period for stocks is now only three or four months. Presumably that includes those held by mutual funds and etf’s.

Is it a new impatience or nervousness on the part of investors and managers? Or is the average holding period being distorted by ‘flash-trading’ firms?

Actually, the dramatic trend to shorter holding periods began 50 years ago, long before flash-trading entered the vocabulary.

According to the NYSE Factbook, the average holding period for stocks in 1960 was 100 months (8 years). By 1970 it had dropped to 63 months (5 years). By 1980 it had dropped to 33 months, by 1990 to 26 months, by 2000 to just 14 months, and in 2010 just six months.

There are a lot of critics blaming it on the supposed stupidity of new investors, and waiting for the time when they will come to their senses and become ‘investors’. But the trend to shorter holding periods began 50 years ago, not with new investors or the new generation, and I don’t think it will ever go back to the old ways.

Here’s what I believe were the influences behind the dramatic change.

Until the early 1970’s stocks traded on a fixed commission set by the NYSE, up to 2% each way (or 4% in and out) of the total value of the shares being traded, with extra fees for smaller transactions sometimes doubling the cost.

Additionally, the availability of mutual funds to any significant degree was still years away. So there was not the ability to trade an entire portfolio in one or two transactions. If one wanted to change a diversified portfolio it was a case of separate costly trades for each individual stock.

In the early 1970’s Congress and the SEC required the NYSE to phase out fixed commissions for larger transactions, and ended them for all investors in 1975. That opened the door for discount brokers, and then deep-discount online brokers, until we now have commissions as low as $7 per transaction, regardless of how many shares are traded.

That was followed by the explosive growth of available mutual funds by which investors could swap an entire portfolio with just one phone call, and later just a click of a computer mouse, with no transaction cost if handled directly with the mutual fund, and only one small commission if handled through a discount broker.

There was also a generational influence. In 1960 only 15% of households had stock market investments. But a new more affluent generation came along, benefiting from the strong economic recovery after World War II, and with no scars from the Great Depression of the 1930’s. By 1995 more than half of households had stock market related investments.

The introduction of tax-deferred IRA and 401K programs, and automatic payroll deductions contributed significantly to the confident new generation’s growing interest in the stock market.

In the red-hot market of the late 1990’s they took advantage of the ability to jump on a trend, ride it awhile, take the profits and move to the next hot area. A lot of money was made in that manner. It didn’t work out for many in the long run as they became too confident and aggressive, creating the dotcom and tech-stock bubbles that burst. Before they realized what had happened many had huge losses. However, the bursting of the dotcom and tech-stock bubbles only reinforced their lack of interest in buying and holding through whatever comes along.

Meanwhile, Wall Street firms, always ready to fill a need with new products, introduced exchange-traded-funds, which trade like a stock during the day, making it even easier to trade an entire portfolio than with regular end-of-day priced mutual funds.

And perhaps more important, ‘inverse’ mutual funds and ‘inverse’ etf’s were introduced, designed to make money in down markets, making it easy for investors and money managers to go after profits from market declines without the more complicated use of short-sales. The potential reward of not only keeping profits already made in a rally, but going after more profits from the subsequent market decline, made buying and holding through whatever comes along even less attractive .

It’s been a steady and dramatic trend that began in 1960, therefore prior to the problems buy and hold has run into over the last 12 years (which no doubt have further eroded any chance of its recovery as a viable strategy).

It is a problem for many investors (and their financial planners), who understandably still want to believe in their father’s buy and hold investing strategy. Anything else requires just too much learning, attention, and effort in their already busy lives.

I believe it’s a permanent change. I can see no influence that would revive the 1960’s strategy of holding stocks and mutual funds through times of trouble, not with the alternatives available. A long period of positive market performance would not even do it. The decline in holding periods has been steady through 50 years of bull and bear markets.

Will shorter holding periods make for more frequent bear markets? I doubt it. Over the last 110 years a bear market has come along on average of every four or five years. That held true back when holding periods were five to eight years, and in the years since. However, it could make a difference in the severity of downturns, if a larger percentage of investors are unwilling to hold through the declines.

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Sy Harding is president of Asset Management Research Corp, and editor of www.StreetSmartReport.com, and the free market blog, www.streetsmartpost.com.

These reports reflect our opinions and are based on our best judgment, but no warranty is given or implied as to their accuracy. Past performance does not guarantee future performance.