Inevitably, every investor, especially those who enjoy reading personal finance blogs, will want to give trading a shot. I certainly tried my hand at trading my personal investment accounts for many years. Many brokerages advertise their trading platforms on television, luring you into the belief that you can make money with trading.
Recently, a reader of the White Coat Investor forum (NapoleonDynamite or ND), discussed his experience with short-term trading in a guest post on the WCI blog. He has been trading a tiny portion of his overall portfolio ($50,000) for the past year, and he has beaten the market over that time period.
But most traders historically underperform the market. One study found that the most active traders in their study cohort did the worst, underperforming the market by 6.5%.
But why do traders do so poorly when they are putting in so much time and effort? There are three major reasons explaining their underperformance.
Time out of the market
This is the biggest source of underperformance in the market. The stock market always has a positive expected return. If it did not, there would be no reason to invest in the market and it would decline until there was a positive expected return.
If the stock market always has a positive expected return, then you should always have your money invested. Having money on the sidelines is a mistake. Keeping your powder dry is a popular trading adage, but it erodes your investment returns.
ND discussed how he made some mistakes during his year in trading, including sitting on the sidelines after Donald Trump was elected and the stock market rose.
Your decline in expected returns is correlated with how long you sit on the sidelines. For example, if the stock market is expected to return 8%, then if you are invested in the stock market half the year and “waiting for opportunities” during the other half of the year, then your expected return is 4% (8% x 6 months + 0% x 6 months).
This argument is similar to why a windfall should be invested in a lump sum rather than through dollar cost averaging. Historically, lump sum investing outperforms dollar cost averaging 71% of the time, and the average amount of overperformance is precisely correlated to the length of time the investor is on the sidelines of the stock market.
A way to attenuate this effect is to invest in the total stock market when you are waiting for trading opportunities and would otherwise be on the sidelines. The problem is that most traders have money on the sidelines because they believe the stock market will fall, so they would be hesitant to employ this strategy.
Trading is not free. The brokerages aren’t advertising on television as a service to investors. They want to make money off of your trading activity. They do this through two methods: bid-ask spreads and commissions. Just like how the currency exchange station at the airport makes a few pennies on every dollar you exchange for euros, investment banks make fractions of a penny on every dollar you trade. Commissions are also pretty low, and they have been declining over the years. However, if you trade frequently, these transaction costs can add up.
Consider an example of a trader with a $50,000 trading portfolio who buys and sells 50 times a year. He loses 0.01% on each trade as a bid-ask spread, and pays $5 per trade in commissions ($500 total for 50 buy orders and 50 sell orders). Over the course of a year, he loses 0.5% of his portfolio value in bid-ask spreads, and 1% of his portfolio from commissions. While the transaction costs of each individual trade seem minuscule, they add up to 1.5% in transactions cost over the course of a year.
If not managed correctly, taxes can significantly reduce your expected returns. If you do short-term trading within a taxable account, you will be accountable for short-term capital gains, which is taxed at ordinary income. If you invest over the long-run, you pay taxes at much lower rate.
For example, physicians in highest tax bracket will pay 39.6% in capital gains tax for short-term trades. These same physicians will only pay 23.8% (20% long-term capital gains + 3.8% Affordable Care Act tax) for long-term trades.
The way for short-term traders to eliminate the erosion of returns from taxes is to trade in a tax-deferred account such as an IRA. Short-term and long-term capital gains are treated the same within these accounts.
Trading increases your portfolio volatility
If you could always be invested in the market and traded without transaction costs or taxes, then the expected return of trading would be very similar to that of long-term investing. The problem is that the volatility of your returns would still be much higher with a trading portfolio, because of the lack of diversification. Traders will typically concentrate their trades within a few positions, while an index fund investor invests in thousands of stocks via a single index fund.
Trading as gambling
The high volatility of a trading portfolio can give the trader an illusion that they are beating the market when they were actually just lucky. This early success can lull them into believing that they are doing well, and they may put more and more of their money in the market.
On the other hand, when some traders start losing money, they get trapped in a gambling mentality. They will continue to trade to “get back to even.” Perhaps they will put more and money into their trading account. Unfortunately, for some people, trading becomes more about the thrill of a winning trade than about making money.
The stock market is designed to favor long-term investors. Transaction costs and taxes significantly erode the returns of traders. Keeping cash on the sidelines waiting for the perfect trade also hurts overall returns. As a result, trading leads to lower returns with more volatility compared to index fund investing. That is a losing proposition.
What do you think? Have you ever tried your hand at trading? Do you think time out of the market, transaction costs, or taxes hurt your trading returns?