Portfolio turnover refers to the frequency of buys and sells in an investment portfolio.
In general, a lower portfolio turnover ratio is better, if you are buying stocks to invest in good businesses over the long term. You can calculate the portfolio turnover ratio quite simply. It is the higher of:
Buys and Sells in One Year
Divided by the average of
Portfolio Starting and Ending Balance
Or, displayed differently,
= (Higher of Buys (or Sells) in One Year) / (Average of Portfolio Starting and Ending Balance)
This formula will give you a percentage, with 100% implying an investor who “turned over” his/her entire portfolio in a given year.
The higher the percentage, the greater the turnover.
If you ever see “share turnover” when researching stocks, it is a similar concept.
So what the portfolio turnover ratio tries to do is uncover the transaction activity of a portfolio manager. You’ll often see these statistics used to measure fund managers or index funds.
Generally buy and hold investors see a lower turnover ratio as better, because it tends to lead to better performance over the long term. Let’s tackle several reasons why.
1 – Lower Portfolio Turnover Means Less Taxes
We should all know that every time you sell a stock, you have to pay taxes on any gains (unless you are investing in a tax advantaged account like a 401k or IRA).
This is amplified for investors who turn over their portfolio greater than 100% each year, because short term taxes (with holdings less than 1 year) have been higher than long term tax rates (holdings over 1 year).
The benefit to not selling a stock which has risen in price is that you don’t have to pay taxes until you sell.
Over the long term, the benefits of not paying taxes on your winners really compounds to large sums over time.
Take this example from a great book by Robert Hagstrom called The Warren Buffett Portfolio:
The Amazing Effect of Compounding
Start with a $1 investment that doubles in value every year.
1) Sell the investment at the end of the year, pay the tax, and invest the net proceeds.
Do the same thing every year for 20 years.
End up with $25,200 clear profit
2) Don’t sell anything.
At the end of twenty years, end up with $692,000 after-tax profit.
What an incredible example of how interrupted compounding can really stifle the return potential for investors, especially those who pay taxes from high portfolio turnover rates.
2 – Lower Portfolio Turnover Means Less Stock Price Randomness
In the same book, Hagstrom uncovered a fascinating study about the correlation between stock prices and earnings performance over a range of time periods.
We all kinda know that stock prices follow earnings; investing legend Peter Lynch said it himself.
But the exact scope of it I’ve never seen quantified until seeing it in this book. From a laboratory group of 1,200 companies over four sets of time periods—five, seven, ten and eighteen years dating between 1978 to 1995—Hagstrom and his team discovered the following correlations between stock prices and earnings performance:
- 3-year holding periods: correlation = .131 to .360
- 5-year holding periods: correlation = .374 to .599
- 10-year holding periods: correlation = .593 to .695
- 18-year holding period: correlation = .688
Where correlation describes what percentage of price variance was explained by earnings variance.
This is a key finding for investors because something that makes investing really hard is a phenomenon called Mr. Market.
The stock market is priced based on expectations of its participants, and so at times you’ll see great companies trade at undeserved prices on either sides—expressed by “the manic emotions of Mr. Market”.
Because of the group nature of the market, this emotional nature can cause stocks to become sorely mispriced due to overblown concerns or irrational exuberance.
And like John Maynard Keynes once said, “the markets can remain irrational longer than you can remain solvent”.
This means that even if you are investor who is excellent at identifying great businesses which produce fantastic business results, the performance of your portfolio could be very poor especially if you have shorter holding periods.
And you can directly measure your average holding period using the portfolio turnover ratio.
The Correlation Between Portfolio Turnover and Average Holding Period
I created a table which illustrates various portfolio turnover ratios and the average holding period implied by each:
We can use a simple example to illustrate why portfolio turnover and an investor’s average holding period are directly connected like this.
Say we have an investor with a portfolio of 10 stocks, each evenly making up 10% of the portfolio.
Say the portfolio was flat for the year. If this investor were to sell 5 stocks in the first year, this would result in a 50% portfolio turnover ratio:
Each stock value = $10
5 sells = $50,
= $50 / $100 = 50%
If the investor continued to do this throughout a career, the average holding period of stocks in his/her portfolio for this investor would be 2 years.
- This is because, in the first year, 50% of the stocks were not sold and 50% were. If we were to say that, after year 1, 50% had 1 year holding periods and 50% had 1y+.
- Of the remaining 50% (or 25%), after year 2, 50% of those would have 2y periods and 50% would have 2y+.
- Of the remaining 50% (or 12.5%) after that, you might have 50% getting sold for an ending time period of 3y while another 50% are held and have 3y+ holding periods.
This would continue to go on and on. With all of the rest of the portfolio at 1 year holding periods, you eventually have an average holding period to rest around 2 years, with the longest holdings contributing the most to pushing the average above where the majority lie (at a 1-year holding).
Applying Portfolio Turnover to the Average Investor
Not only do the facts behind low turnover portfolios make sense, but the evidence bears it out as well.
Consider an investor like Warren Buffett. Buffett has been known to own some fabulous companies for many decades—killer investments like Coca Cola, American Express, and GEICO. A few quotes from Buffett on averaging holding periods:
- “Our favorite stock holding period is forever”
- “Lethargy bordering on sloth remains the cornerstone of our investment style”
- “If you are not willing to own a stock for 10 years, do not even think about owning it for 10 minutes”
I really liked this quote, relating great stock winners with an elite athlete like Michael Jordan, which many of us sports fans can relate to:
“When carried out capably, a [low-turnover] investment strategy will often result in its practitioner owning a few securities that will come to represent a very large portion of his portfolio. This investor would get a similar result if he followed a policy of purchasing an interest in, say, 20 percent of the future earnings of a number of outstanding college basketball stars. A handful of these would go on to achieve NBA stardom, and the investor’s take from them would soon dominate his royalty stream. To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.”
From these comments and many more, we can quickly understand how deeply important the idea of holding great businesses over the long term has been to Buffett’s success as one of the best investors of all-time.
The truth of the matter is that you can’t hold many stocks for a very long time with a high portfolio turnover ratio—the mathematics literally just don’t work.
What that magic portfolio turnover ratio will be for the average investor is very personal, and should be decided based on the type of stocks you choose to buy and the kind of temperament you have as a long term investor.
We can borrow a few examples from Hagstrom’s book for a range of good turnover ratio values.
One straight from the book came from a study from Morningstar on the performance of 3,560 domestic stock funds. Over a 10 year period, the funds with a turnover rate below 20% had 14% higher average returns than those with turnover rates above 100%. Though that study might be considered outdated today, it does reinforce the idea that no activity is oftentimes better than a flurry of trading.
Another suggestion straight from the author was that the average investor target a turnover rate of between 10%-20% as a general rule of thumb. I like this as a starting framework because it implies an average holding period of 5-10 years.
This white paper from 2010 reported that Buffett’s turnover rate from 1977-2010 for his company Berkshire Hathaway looked like the following:
To have a median portfolio turnover rate of 2.1% is absolutely insanely low, and to have many years where Buffett did nothing (turnover rate = 0%) shows that he really practiced what he preached.
A median turnover rate of 2.1% implies an average holding period of greater than 25 years, which had to be accentuated by Buffett’s biggest holdings on a percentage basis having multi-decade holding periods.
By contrast, here was the rate of turnover for actively managed funds compiled from the Morningstar database around the same time:
To be sure, the average investor can look to Buffett’s example as an ideal to strive for, but we also have to be careful as we do this.
For starters make sure you take this data in context.
By the time that this turnover rate was first reported by the white paper (1977), Buffett had been a full-time, professional investor for 20+ years already. To say he had a circle of competence and knew what he was doing would be an understatement.
To really have the confidence (and success) to buy the best businesses and watch your investment compound for many years, you need to have a great understanding of what a good business looks like and at what price to purchase them at.
But it can surely be doable for those of you who have the determination and patience to do so.
I think the best portfolio turnover strategy is one with an ideal framework, but one that is flexible.
I like Peter Lynch’s quote about selling and holding: “Selling your winners and holding your losers is like cutting the flowers and watering the weeds”.
As you get better and better and picking stocks and finding those great compounding businesses, you should see some winners crop up and take bigger and bigger portions of your portfolio. It’s up to you at those times to let them continue to ride, as your capital continues to compound alongside them.
But at the same time, don’t be scared to “cut the weeds” when you find out that a company which you thought was a great business ended up being a poor performer after all.
It makes no sense to make poor buy/sell decisions on the stocks in your portfolio solely in the name of keeping a low portfolio turnover ratio. If you go back to the chart on Buffett’s, you’ll see that even he had a huge rate during 1984 and 2007, with the 1984 approaching 40% and falling way outside of what is normally associated with long term average holding periods.
Use a good portfolio turnover ratio as a framework and another tool in your portfolio management strategy.
Be flexible with that framework, but also commit to achieving a consistently low turnover as you invest over many years.
Well, if you want to have success like Buffett did, that is.