Why does a stock like Apple seem so "obvious" in hindsight? Is it really hopeless to think that an intelligent investor can't find the next one before it hits big? After all, one Apple can erase lots of mistakes, can't it?
Sure, it's absolutely possible that an intelligent investor could discover the next Apple before everyone else does. Problem is odds are heavily against it. Let me explain why... For the purposes of this post I will lump traders and individual stock investors together and refer to them jointly as "traders" -- it is not quite fair but close enough for the purposes of the post and I will make the distinction at the end.
All active traders will collectively lose to the market every single year. This is not because they're not intelligent or don't do their research. It is because they are playing a huge zero-sum game, except every move in this game (i.e. every trade) carries with it non-zero cost. You will always pay commissions and spreads. If you trade in taxable accounts you will also pay taxes. On top of it plenty of active traders pay for all sorts of tools, subscriptions, books, programs, etc. which should also count against their net earnings (though few really track this stuff). On top of that active traders spend a lot of time on research and execution of their trades -- and we all know that time is money. Though I suppose it should not count if trading doubles as a hobby. In any case, all of those pennies and dollars add up to huge amounts over the years, especially if you are a heavy trader in a taxable account.
Try a simple thought experiment. Rank every investor in the world by their IQ or investing acumen or trading intelligence or any other measure you like. Then take the dumbest 90% and have them be permanently invested in something like Vanguard's LifeStrategy or Total Stock Market Index fund or some other broad low-expense index fund -- all of these have the same expected risk-adjusted returns. Put all the dividend and interest re-investment on automatic and don't even let the dummies touch their accounts. Then take the smartest 10% and let them loose to do whatever research and trading they wish to do. Then compare the results after, say, 30 years.
You will find that only a tiny fraction of those smartest 10% will beat the dumb 90% after 30 years. This is not my theory. This is basic and inevitable math. The smart 10% that trade actively will collectively determine the market returns as they go long or short in various stocks and bonds. The dumb 90% that does nothing will simply participate in the average returns of this market. The collective returns of the smart 10% and the collective returns of the dumb 90% will be identical before expenses. Again, basic math. There's nowhere for the extra genius alpha to come from besides other geniuses, since dummies merely passively track the market. Every dollar of above-market returns of one genius must come via a dollar lost to the market by another genius.
But after expenses the average dummy will easily beat the average genius because the dummy' expenses will be miniscule compared to genius's expenses (because of all those frictional costs we mentioned: commissions, bid-ask spreads, taxes, etc.) It is certainly plausible that some of the smart 10% will end up on top, even after paying higher expenses year in and year out. But the majority of them will certainly lose to the dummies. The only question is whether 80% of geniuses will lose or 90% or 99%. Again, this is not a slight on intelligence of active traders. It is the inevitable outcome of playing a zero-sum game with non-zero costs as our geniuses choose to do.
Are You Really The Next Warren Buffett?
This wouldn't be so bad if there was some evidence of lasting skill among investors, but there's literally just a handful of investors who managed to beat the market over multiple decades despite tens if not hundreds of thousands who attempt to do so professionally. Individual numbers are of course impossible to come by, but just calculate what percentage of your friends, colleagues, and relatives went on to become self-made millionaire traders. As I said, it's just a question of whether 80% or 90% or 99% will lose.
The history of mutual funds confirms this. Look at any one year and you'll find thousands of funds that crush the market. Look at any decade and you'll find dozens if not hundreds of them. Look at 30 years and you'll be able to count such winners on your fingers. Look at 50 years and you won't find any market-beating mutual funds at all and will be down to just a few individual investors like Warren Buffett and probably some others who prefer to stay out of the spotlight.
In effect, when you decide that you will trade actively you are setting your sights on becoming the next Warren Buffett or close to it. That is because most people can expect to be invested for at least 50 years and hopefully longer and we just discussed the pitiful 50-year track record of professional investors. Becoming the next Warren Buffett is a great personal goal, but staking your financial well-being on it via trading is simply not wise. It's not much different than quitting or at least downgrading your job and training all out to become a professional basketball player. In both cases you'd be taking an on-going financial hit in hope of eventual financial gain despite the long odds.
When you are trading actively you are competing not with the average investor (the dumb 90% in our experiment above), but with the best of the best, including ones that have much more experience than you, better research than you, better rumor and inside information access than you, better trading platform than you, cheaper commissions than you, and much more capital than you. You do have the advantage of small positions that can easily be taken and exited without moving the market, but in every other respect your opponents are better equipped. And both you and them combined will still lose to the average passive-investing dummy over the decades.
I am an active trader myself (I won't discuss the details here). I say it only to let you know that I am quite familiar with both sides of investing, active and passive. I do not imply that active traders are stupid for what they do. But I do think that in pursuit of the next great trade a lot of them completely miss this bigger picture of a giant zero-sum game with awfully long odds. Once you get into the trading game, it's very tempting to start keeping score of your winning trades while writing off losing trades as isolated incidents or being somebody else's fault (e.g. Bernanke unfairly propping up the market) or fixable mistakes. The truth is that those losing trades are mathematical inevitabilities. It is vitally important for every trader to be honest with himself about this. Accept full responsibility for all of your trades, winning and losing, and appreciate the zero-sum, net-loss-after-expenses nature of the game. That's why I urge all active traders to benchmark their returns.
Improving Your Odds
If you do decide to go the active route there're a few things you can do to improve your odds:
- trade or pick stocks in tax-sheltered accounts like IRA or 401k. Taxes will absolutely crush you even if you manage to beat the market consistently in a taxable account. If the market returns 8% you have to beat it by 4% annually just to stay even if you are trading in a taxable account in the 33% tax bracket. This is a terribly high bar to clear year in and year out
- look for lowest commissions and best brokerage freebies. A lot of brokerages offer all sorts of incentives for moving your account to them, often including free trades. You can make a nice racket of this with your IRAs, pocketing $500+ annually for moving accounts to different brokerages (typically they expect you to stay put for a year) and getting free trades on top of that. If your account is substantial you could try to negotiate even more favorable deals for yourself
- stick to buy-and-hold as much as possible. This is the difference between individual stock investors and traders that I referred to early in my reply. Buy-and-hold for individual stocks has many of the same low-expense benefits as buy-and-hold for index funds. If you trade frenetically you are virtually ensuring your failure due to commissions and spreads (and, again, taxes if trading in taxable accounts). Long-term buy-and-hold of individual stocks has much, much greater chance of winning than frequent trading. But odds will still be against you
- look for academically- and time-proven strategies, such as value investing (of which dividend investing is one type)