Understanding Overtrading
Overtrading occurs when the trading volume exceeds the optimal level for achieving investment objectives, leading to unnecessary costs or market risks. Often driven by the emotional responses of traders or financial incentives for brokers, overtrading can diminish investment outcomes through increased fees or poor market positions.
Forms and Implications of Overtrading
Broker-Induced Overtrading (Churning)
When brokers excessively trade stocks to increase their commissions at the expense of clients, the practice is called churning. It’s prohibited by securities law due to its manipulative nature designed solely to profit the broker, not the investor. Churning is a personification of greed wearing a necktie, using clients’ accounts as its personal income source.
Self-Induced Overtrading
Individual traders often fall victim to overtrading in their pursuit to recover previous losses or capitalize on unrealized gains. This emotional trading can lead to unsound trading strategies where more trades equate to better chances of recovery, akin to a gambler’s fallacy in the financial markets.
Regulatory Oversight and Investor’s Defence
The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) provide oversight to prevent and penalize broker-induced overtrading. Investors are advised to monitor their account activities closely and opt for wrap accounts where feasible to avoid per-transaction commissions.
Preventative Strategies for Investors
Avoiding overtrading requires a disciplined approach to trading:
- Set Clear Trading Limits: Defining strict buy and sell rules can help maintain trading discipline.
- Utilize Risk Management Tools: Incorporating stop-loss and take-profit orders can mitigate the risks.
- Focus on Long-term Goals: Keeping an eye on long-term investment goals rather than short-term fluctuations helps in reducing overactivity.
Related Terms
- Day Trading: Buying and selling securities within the same trading day, often with high frequency.
- Portfolio Management: The art and science of making decisions about investment mix and policy to match investments to objectives.
- Leverage: Using borrowed capital for an investment, expecting the profits made to be greater than the interest payable.
- Investment Strategy: A set of rules, behaviors or procedures, designed to guide an investor’s selection of an investment portfolio.
Recommended Reading
- “The Intelligent Investor” by Benjamin Graham - Provides foundational knowledge on value investing and includes strategies to avoid overtrading.
- “Trading in the Zone” by Mark Douglas - Offers insight into the psychological challenges of trading and how to overcome them.
Overtrading, whether by the hand of a greedy broker or an emotional investor, destroys the charm of portfolio growth. As they say, sometimes doing less is more in the world of investing. Embrace the tortoise’s strategy: slow and steady wins the race—or in the case of trading, might just save your purse.
