Monday, May 14, 2012

You’re Not Diversified Enough for a Reason

The discussion of Apple’s dividend decision resulted in the exploration of factors that occur in real-life that deviate from the Perfect Capital Market Assumptions of financial theory, and how these impact our Financial Strategy.
The final item under this set of assumptions is Absence of Transaction Costs. This is a deceptively simple assumption, yet holds a large amount of implications.

Diversification is Key
One of the most basic principles of investing is to diversify your portfolio - having too many eggs in one basket increases your risk. Sure, if you invested 100% of your money in Google or Apple back in the day you may have hit a home run, but only in hindsight do we know that these were the correct picks.
The investment is made before you know the outcome. There were a lot of people who thought Webvan was the next Amazon, and you would have no money left if you had put 100% into that.
The “eggs in one basket” investment strategy will ultimately leave you hungry almost all of the time.

Theory Says….
Going to the other extreme, a lot of the highly regarded (Nobel Prize winning even) academic theories such as the Capital Asset Pricing Model assume that the investor is invested in the entire market.
So let’s pretend for a minute that the entire market is comprised of only 100 stocks spread out throughout the world. Furthermore, each of these stocks currently trades for $100. Finally assume that we have $10,000 to invest.
Figure A
If there were no transaction costs, investing in each and every stock is not an issue, and we would own 1 share of each firm in the market (100 x 100 = 10,000 : what we have available to invest).
Now let’s assume a stock trade costs $9.95 per trade. Figure A shows how much we actually have invested in the market after paying for the trade, and we can see that the fewer stocks we own the more we have invested, since we have made fewer trades that we had to pay for.
Therefore, because of transaction costs, we will tend towards holding smaller, more concentrated, less diversified (and therefore riskier) portfolios than we otherwise would.

In the Mind of the Investor
Because we have paid something to own the stock, we also experience the fact we begin our investment with a loss! We buy one share of stock for $100, it costs us $109.95. The price needs to go up by almost 10% just for us to break even on the purchase! But that’s not all, since we would still have a loss if we sold it at that point. If we count the buy event and the sell event together (a “round-trip” in trader talk), our stock needs to go up by 20% just to break even!
Of course, if we buy 100 shares instead of 1 share, these percentages are a lot smaller, so again there is an incentive to concentrate investments in fewer securities so we can spread that $9.95 over as many shares as possible.
But there is also a psychological element. The field of Behavioral Finance is a study in and of itself, but one of the things that has come from that field is that our losses hurt us much more than our gains help us. More pain is caused by a $10 loss than the pleasure of a $10 gain.
What happens then is that people hold on to their losers longer than they should in the hopes that the stock will rebound, thereby alleviating all that pain from loss.
With transaction costs, we begin the investment in this painful loss position (remember in the example above we have something worth $100 that cost us $109.95), and we will therefore have a tendency to hold on to this investment longer than we ought.
Conclusion – transaction costs result in investors holding on to investments longer than they should.

Tipping Points
Transaction costs also impact our trading strategy given our expectations of the investment.
Let’s say that we own a stock that will pay out $10 next year, and we have a discount rate of 12% and expect growth of 2% per year. We will value this at $100 using the Dividend Discount Formula, and everyone else in the market is of the same view.
Now the market hears some positive economic news that raises their growth expectations to 2.5%. Because of this, the stock price will rise to $105.26.
We, however, do not believe this economic news and consequently now own a stock we think is overvalued. Because we want to sell high and buy low, our desire now is to sell this stock. However, if we were to sell we would incur the $9.95 cost and we would recoup only $95.31. We are better off holding onto the stock even though it is overvalued.
The change in growth expectations needed to result in a net outflow of $100 given the $9.95 transaction cost is 2.9%. Thus, until the discrepancy between the market’s expectations and ours is great enough, we will not be able to make a transaction that keeps us whole with respect to our value expectations.
Conclusion – transaction costs make immediate reaction less likely, until the gap between the market’s expectations and the individual investor’s is great enough to attain a “tipping point”.

Steps We Can Take
Transaction costs are unavoidable. As an organization, if we are going to acquire or merge with another firm there will be fees we pay to investment bankers, lawyers, accountants, consultants, and others.
Given that transaction costs will occur, our organization’s decisions and behavior may differ from what is “theoretically correct” for valid reasons. However, we also do not want to be led into decision traps (e.g. holding onto losers too long, remaining too concentrated in a line of business) that we can avoid. To that end, we can take the following steps:
Know Your Cost of Capital – as discussed in earlier posts about the Capital Asset Pricing Model, the cost of capital is a “fuzzy” number. The cost of capital we choose to use has a range associated with it. Erring on the high side of that range will allow some absorbing of transaction cost impact without a whole lot of additional work.
Some prefer to model transaction costs explicitly and then apply the cost of capital to the post transaction cost cash flows. This approach is technically incorrect, as the derivation of the cost of capital did not include these items (e.g. it was calculated on pre-transaction cost returns).
Establish Diversification Targets – In order to protect against the tendency to hold fewer investments in the portfolio, a qualitative assessment (using strategic tools) combined with a non-transaction-cost-influenced quantitative assessment can be performed in order to establish targets. By doing this, it changes the perspective of the later analysis as it is not anchored initially on the transaction costs, and they can be layered in and assessed independently.
Establish Exit Targets During a Pre-Mortem – By assessing the conditions and economic signposts under which a divestiture or sale is warranted at the time of the investment initiation, we can establish a more objective target at the onset that will not be influenced later by transaction costs-du-jour. This will help us avoid holding onto investments too long or waiting for a “tipping point”.

Key Takeaways
The presence of transaction costs incents the firm to invest in fewer activities, diversify less, and remain invested longer than traditional theory suggests. By performing up-front analysis of our investments at the time we are embarking upon them, we can mitigate the impacts of some of the decision traps that may be caused later.

·         What examples of negative decisions caused by transaction costs have you experienced or witnessed?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!


  1. Not to be a shill, but note that WellsTrade offers the first 100 trades "free" (I'm sure others do as well). Another form of transaction costs that is assumed away in ECMT is liquidity, as JPMorgan has painfully learned.

    1. Thanks for the comments!

      Liquidity is critical to the market being able to transact - as JPMorgan has experienced recently, and as many (banks, corps, individuals) back in 2008 did.

      A lot of times the liquidity factor shows up in the bid/ask spread - securities that are not as frequently traded have higher spreads than the really actively traded ones. Under that situation some of the transaction cost impacts noted in the post would apply.

      Hopefully more and more offer free trades in the future, and this post can become a relic of a past era!