I'll never forget the first time I met a day trader face-to-face.
He was dating a friend from college and I was a guest at their apartment-warming party. Amidst all the celebrating, I noticed him sitting alone at his living room desk, scanning a complicated-looking screen of stock data on TD Ameritrade.
I was curious.
“What's this all about?” I asked.
“Day trading, man. This is what it's all about. It's the only way to win in the market!”
“The only way?” I asked more than a little skeptically.
After years of freelancing for top financial brands like TurboTax and Mint.com (and serving as editor of I Will Teach You To Be Rich), I was already steeped in disdain for day trading. All of the pertinent research suggested it was a fairy tale — a “hit-or-miss” strategy with a lot more missing than hitting.
But this day trader had proof . . . or so it seemed.
“I don't know man, you tell me,” he gloated while motioning to a balance of $50,000 in his TD Ameritrade brokerage account.
“Told you!” He was beaming with pride as he proceeded to explain why passive investors (those who invest in mutual funds or index funds and then leave their investments alone) were “chumps” and “not cut out for the man's game” of high-stakes stock picking.
I was impressed. Theory or no theory, it's hard to argue with cold hard cash right in front of your face. I entertained the idea that maybe (just maybe) this guy had cracked the elusive “code” so many before him had searched for. And I could see his smile grow wider with each question I asked.
Until, that is, my final question: “But hasn't it been proven that timing the stock market is impossible to do consistently?”
I should have known better. For it was barely two seconds later that he uttered the unmistakable “tell” of every so-called successful day trader.
“No, man. Anyone can time the market if they know what they're doing.”
It was time to unravel this ball of yarn once and for all.
“So You've Never Lost Money?”
What this trader (and so many others) failed to realize is how contradictory their smug logic is. If it were true, it would mean day traders who “knew what they were doing” would rarely — if ever — suffer a loss. Yet I quickly discovered this was not the case.
“Wow! So this is pure profit?” I exclaimed.
“Yeah dude! Well . . . ,” his voice trailed off. “Not exactly.”
His smile vanished in the blink of an eye. “What do you mean?” I asked.
“I got hit with a bunch of losses earlier in the year. Maybe a grand or two of this is gain.”
Or, put another way, the rest covered a $48,000 or $49,000 loss.
I kept that wisecrack to myself. He was a good guy, and I saw no reason to inflict needless pain on someone who was gracious enough to invite me into his home.
That said, his experience is critically instructive to all investors. Virtually all of us have considered day trading at some point. If you haven't yet, it's a safe bet you will in the future.
If you take nothing else away from this post, let it be this: no one (outside of a select few geniuses you are not going to emulate) “knows what they're doing” often enough to beat the stock market on purpose.
[Malkiel's] most controversial claim was that a monkey throwing wet paper towels at a stock chart on the wall could beat an expert armed with statistics and stock picking formulas. Intrigued (and no doubt annoyed) by this statement, the Wall Street Journal took it as a challenge and ran a simulated experiment where people threw darts at stock charts while experts picked stocks deliberately. While the dart throwers didn’t win out (the experts got it right 61 out of 100 tries), the experiment did show the investing public that completely random dart tosses beat the experts 39% of the time.
Now ask yourself: In what field other than investing does a 39% failure rate constitute “knowing what you're doing”? Would you trust a doctor who botched 39% of their surgeries? Would you hire a babysitter who let 39% of their previous children get abducted? Would you call a plumber who 39% of your friends had a bad experience with?
Of course not! But this is what passes for “expertise” among stock pickers. Comforting, or disturbing?
Keep in mind the stock pickers who opposed these “monkeys” weren't cocky amateurs (like the guy I met) but highly respected professionals who work on Wall Street. And “monkeys” still beat them alarmingly close to half the time!
What About Warren Buffet?
At this juncture, many will intervene and say “but what about Warren Buffet?” Yet this objection is as irrelevant as it is misleading.
Warren Buffet is not a powerless outside investor like you or me. When he invests, he gets an active say in the company's strategy, direction, and upper management. While the rest of us can do nothing more than buy or sell, Buffett can influence the day-to-day actions of firms in his portfolio.
Additionally, Buffett has the time and resources to study the market obsessively, day in and day out, every day, week, and month for years. So by the time he gets that impossible-for-you-to-obtain control of a company, he is better prepared than you will ever dream of being.
Finally, Buffett isn't day trading — he buys companies for the long run. He has even said that the timeline of his investments could be infinity — that's long-term!
The Solution: Passive Investing
Now that I've thoroughly demoralized you, I want to offer some parting words of hope. Just because you probably won't be day trading your way to stock market success doesn't mean you can't profit from investing.
It just means you need to approach it from a totally different perspective.
Instead of falling for the siren's song of stock picking, invest passively. Invest in an index fund. Better yet, invest in a lifecycle fund (also known as a “target-date fund”) that not only serves the same purpose as an index fund but also automatically rebalances to preserve your ideal asset allocation as you age.
The beauty of passivity? It replaces stock picking with technology; namely, a computer that invests your money for you across broad swathes of the market instead of trying to pick “the one right stock” that you probably won't find.
You generally won't realize huge gains. But you also generally won't realize huge losses (at least over the long-term). And as every successful investor knows, avoiding losses is — at least — half the battle.
What are your thoughts on day trading versus passive investing? Could a monkey beat your portfolio?