We’ve all heard the saying, “Buy low, sell high.” Seems pretty straightforward, right? Actually, it’s not. In reality, constantly trading in an effort to time the market or pick stocks leads to higher transactions costs and taxes, and introduces unnecessary risks – actually decreasing your chances of meeting your goals.
Zero-Sum Game (Revisited)
In part 1, we introduced the concept of a zero-sum game, and showed how investing is not one. Over time, markets have rewarded investors for providing capital.
Trading, on the other hand, is a zero-sum game.
When I was a kid, I loved collecting basketball cards. My brother and I would get together with our friends and compare cards, and sometimes make trades. At first, it was all about who your favorite players were. But as we got older, it became more competitive, and we tried to collect the cards that were worth the most or that we thought would be worth the most in the future (my first attempt at a retirement plan!)
In this scenario, there was no creation of wealth within the group, simply exchanges of cards between participants. Those who were able to collect the best cards became the winners, but only at the expense of those with the worse cards.
Trading stocks is a similar game. Money isn’t made in the trading; it’s made in the owning. Trading results in some winners and some losers but doesn’t create any wealth.
Prices Contain Information
Of course, despite the fact that trading produces no wealth, it can be tempting to try to actively trade and try to “beat the market”. After all, who among us believes we are average? A study done years ago found that 93% of drivers in the U.S. believe they are better than average.* Of course, the reality is, only 50% of us, whether drivers or investors, can be better than average.
Unfortunately, even having above average intelligence or more experience isn’t enough to find winning stocks with any degree of consistency. A simple example will illustrate why:
Imagine you are an art dealer. You are at an estate sale and your eye catches a piece of artwork you know to be worth tens of thousands of dollars. After careful inspection, you determine it is, in fact, an original and yet the asking price is only $100. In this world of no competition, you might get away with a tremendous profit.
However, what would happen if just before you make the purchase, a competitor steps in and makes a higher offer? With only two bidders, it is likely you will purchase the painting at a price that will simply compensate you for your time and the risk of reselling the piece, plus a small profit.
The stock market has literally thousands of incredibly sophisticated investors constantly analyzing company financials and future prospects, looking for mispriced stocks. How likely is it that you will be able to find a stock that is sure to bring a huge payday?
Does that mean the prices are always correct? Of course not. Being correct or incorrect only applies to questions like, “What is the sum of 2+2?” Stock prices depend on hundreds of variables and an uncertain future. What we can say is that the stock market is extremely competitive and prices are fair, given currently available information.
Follow the Money
If beating the market by actively trading stocks is so difficult to do, why is there so much emphasis put on trying to predict the direction of the market or pick winning stocks? As with most things in life, you just have to follow the money. There are two big proponents of the myth that frequent trading is good for your financial health: financial firms and the media.
You’re probably familiar with a commercial that portrays a baby in high chair trading stocks online and making piles of money. Of course, Wall Street wants you to think about making profitable trades is easy. Why? I can tell you it’s not because they think you are likely to actually make good trades. No, the reality is very simple:
They make a commission on every trade.
I find it almost comical that many of these firms offer free newsletters, fancy charts, and analysis all under the guise of providing you, the investor, with a better experience. In reality, financial firms design all of these services with one purpose, and one alone: to get you to trade as much as possible, so they can collect more commissions.
The media’s incentives are a little different. Their goal is to attract viewers or readers so they can sell advertisements. A headline that reads “Just sit tight and be patient” day after day, probably won’t interest a lot of readers. So instead they make wild predictions or impossible promises:
“The Crash is Coming: Sell Now”
“The Five Stocks Sure to Double This Year”
Those are the kinds of things that grab people’s attention. Unfortunately, following their advice very seldom works out. As Steve Forbes once put it:
“You make more money selling advice than following it. It’s one of the things we count on in the magazine business — along with the short memory of our readers.”
Patience and Discipline
Who among us wouldn’t like to win the lottery? The hope of hitting the jackpot has made gambling a $70 billion industry in the U.S. Unfortunately, the vast majority of gamblers lose a lot more than they ever make, while the casinos make big profits.
Likewise, finding the next hot stock or timing the market perfectly in hopes of a big payoff can be very appealing. But the odds of getting it just right are similarly slim. Meanwhile, more trading means higher fees and more taxes, further reducing your returns. Instead, we promote a disciplined, patient approach that is designed to make sure you keep your share of market returns. (More on this in Part 4)
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