• Ryan Reeves

On Conviction and Turnover

Warning: this post is going to be more philosophical than practical

It seems like conventional wisdom that buy and hold investing is best and that low portfolio turnover is good. Maybe not conventional wisdom in the broad sense but among fancy investor people. I’m here to take the other side, just for fun.

First, let’s make sure we understand why this belief is held. Long-term capital gains taxes are only 15% and short-term capital gains taxes are at least double that (we’ll use 30% for illustration). Therefore, always selling stocks makes it much more difficult to outperform.

Let’s take two scenarios over 20 years. One is where a stock compounds at 15% for 20 years and you sell at the end of the period. And the other is where you get a 30% return every year, but it’s a different stock for all 20 years and you sell the day before long term capital gains taxes kick in. What would be the differences in returns?

If we start with $100, in the first scenario, you’re left with $1,406, a 14x increase! ((100* 1.15^20 – 100)* .85) + 100)). That’s a 14.3% CAGR.

Calculating scenario two is a bit trickier.

  1. ((100 * 3) – 100))*.7)) + 100 = $121.0

  2. ((121 * 1.3) – 121))*.7)) + 121 = $146.4

  3. ((146.4 * 1.3) – 146.4))*.7)) + 146.4 = $177.1

  4. Etc…

The easier way is to just take the tax hit from the return and CAGR it. In math speak, that would look like this: ($30 * .7) = 21. So you’d be left with 45x your money, or more than 3x the buy and hold investing. But 30% returns aren’t typically easy to come by…

So basically now we can find what return we would need every year to equal our nice buy and hold scenario. In other words, what return would we need to equal a 14% CAGR in the higher short term capital gains bracket?

($? * .7) = 14.3%

? = 20.4%

So we’d have to find companies that can return at least 20% annually for our short term trading to work out. Now, of course, it would be ideal if we could find those 20% companies and hold them for at least one year. Then our CAGR would be 17% annually, or a 23x increase over 20 years ($20 * .85).

Ok, geez! That’s a lot of numbers.

It goes to show you that long-term buy and hold investing makes sense because of the tax implications. On the other hand, I could argue it’s more difficult to find a company that can compound at 15% for 20 years than find one new idea per year that can go up at least 20%. It’s actually an interesting thought experiment. I would guess the base rates on the former are much lower than the latter.

So we’ve covered the tax piece but there is also the compounding knowledge piece. More portfolio turnover means that you are always selling companies you know really well for companies you don’t know as well. This knowledge anti-arbitrage (I don’t know the word for this) makes having conviction much more difficult. But what if conviction is overrated?

I know, this is somewhat heretical but I like taking the other side of an argument. I think it stretches us and where that discomfort is, growth often follows. Conviction happens when we really believe in something. It’s necessary that we have some degree of conviction in the business or else we’ll resort to the whims of daily stock prices. On the other hand, I’ve seen conviction really hurt people. They’ll double down on a stock because they’ve done all this homework and they just know they’re right! But the world doesn’t conform to our beliefs. If a stock is plummeting, that makes me nervous. The market isn’t some dumb entity. It’s made up of brilliant fund managers, smart retail investors and everything in between. Sure, there are the occasional huge dislocations, but by and large, I’d say things usually aren’t wildly mispriced, especially with companies that aren’t growing much.

So what gives? What’s the point of all this?

I guess what I’m trying to say (apologies for only getting to the point 700 words in) is that high conviction and low turnover aren’t good in and of themselves. Just because you have high conviction and never sell a stock, doesn’t mean your returns will be good. Sure, it might give you a higher probability of beating the market because stocks generally go up over long periods so selling would go against that probability. However, what about crushing the market?

The point of successful investing isn’t to hold the best businesses. It’s to get world-class returns (to be fair, returns aren’t everything to everyone. It’s all about your own financial goals. At this time, however, my goal is to put up some of the best numbers possible). Holding amazing businesses usually leads to that; it’s an input and returns are the output. Focusing on the inputs is incredibly important to tune out the noise but every once in a while, it’s crucial to check on the outputs to see if your inputs need tweaking. For example, say you’ve underperformed for 5 years. Is it time to make a change? Or if a stock you’ve held for 2 years is a loser, is it time to move on? How do you know?

I think it’s all about first principles thinking. Low turnover and high conviction are typically great inputs to high returns. But they aren’t always. There are edge cases and we need to be able to always monitor the opportunity costs.

As my friend Nick Dennis would say, it’s about principles not proxies. Low turnover is a proxy. It’s not a principle. Is it possible to get higher returns with higher turnover? Emphatically yes; therefore it’s not a universal truth. One of the only universal truths in investing is that if you’re holding a stock that goes up, you’re making money. Most everything else is an abstraction. This is why I don’t hate on traders. They are solely focused on the thing that really matters. Stocks going up. I know this is heretical in the investing world but it’s just something I’ve been thinking about.

To be clear, I’m not becoming a day trader :)

But it’s interesting to think about what assumptions we believe as truth when in fact they are proxies: conviction and turnover are the ones that came to mind. I’d love to hear from you if there’s anything that you think of.


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