This week I came across an article on-line published by the folks at the Motley Fool. For those of you who do not know, this company gives a lot of good sounding investment advice, but in reality they are similar to every other “traditional” financial advice provider out there. At the end of the day you are paying them for advice on what companies to buy, and which to sell. In other words, they believe in stock picking. But according to this article, not a lot. I’ll explain.
The first point they raise in the article is that you should not buy high and sell low; but that is what everyone does. The author even confesses their guilt in purchasing a rather famous, now defunct, stock at a very high price. You might as well lifted this part of the article from one of our classes. Their point: don’t let emotions get in your way. Stay disciplined. That is good advice.
But then the advice gets… murky. They say don’t “day trade”. I’d agree. The research shows that the more people trade, the worse they do. They give an example of someone doing 10,000 trades a year and raking up $100,000 in trading costs. Hard to overcome. But that is a ridiculous example. Trading once a day would only be 730 trades a year by comparison. So that begs the question, what is day trading? If “day trading” is bad, then is just trading “once and a while” ok? The fact that the article hides is that whether you trade once, or hundreds of times, the research shows your likelihood of beating the market is not good. You can’t both believe the market is beatable, and yet be against day trading. Here is why.
Assume that the M.F is right. Let’s say you (or they) can pick stocks with the probability of 70% being correct, at a gain of $100 per time (and when I mean gain, I mean gain as in better than what the market as a whole did). Out of the rest lets say 20% of the time you break even (or match the market), and 10% of the time you loose $100 (or do $100 worse than the market). If I do 730 trades, one a day, I will realize a gain of $36,500 assuming I pay $10 per trade in commission. I think we could all agree that that would be day trading, right? And if these are trades of $10,000 a piece, I don’t need a big price movement to get ahead $100.
Now let’s shrink this down to 10 trades. Hardly day trading. Well, in that case I would make $500 based on those same costs and odds. In both cases, since the market is “beatable”, it pays to trade. In fact trading more doesn’t hurt you (unless you perhaps take it to the absurd extreme like the article does)! It can actually help you to a point.
Now, let’s flip it. Let’s look at real life probabilities. Lets assume that 30% of your picks work and profit $100, 40% break even, and 30% lose $100. If you did 730 trades, you would lose $7300. If you did 10 trades at these odds, you’d be out $100. Your winners cancel your losers, and you’re out the costs of playing the game. In the real world, you would have been better off just owning “the market” and not trading.
Does anyone get the irony of this article? The Motley Fool sells you on the idea of letting them help you pick a few winning stocks by paying for their advice. Just trading a “little bit”. Inherent in this proposition is the belief that the M.F CAN pick winning stocks. But I just showed you above, that if the M.F CAN pick stocks, they should give you TONS of picks so you can make TONS of money. They SHOULD give you a trade a day. Here is why they don’t. If they did, they’d rack up huge loses for their investors through trading costs. They know they can’t pick winners consistently. By keeping trading to a minimum, they hope to hit just a few more winners than losers, just enough to keep you along for the ride for another quarter.