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Active Trading and The Perils Surrounding It

Gambling on purchasing a new washer when you see the latest price drop may make you a winner when it comes to saving money on a new appliance. However, when it comes to investing, that strategy, known as active trading or day trading, may not be your best option for winning. Some financial advisors can give a great sales pitch on why you should buy and sell securities for short periods of time. Basically, you are buying and selling stocks on a regular basis. The goal is to take advantage of short-term movements in price on investments that are in higher demand. More often than not though, active trading and the perils surrounding it will not increase your bottom line. 

Why Not

While it may sound great, it doesn’t always bode well for the investor. For example, my company recently took on a new client that ended up wrapped up in a day trading scenario. He had a seven figure portfolio and was shopping around for new advisor. The man initially interviewed with us the year prior to becoming a client. He also interviewed another investment advisor that spouted out a flashy sales pitch, promising bigger, better, and flashy returns. So the client chose to work with the other advisor, that was actually more of a stock trader.

I can’t say I blame him. Compared to very boring Justin who just wanted to do things passively and manage a very good allocated portfolio. The sales pitches for day trading are quite catchy. Remember the old saying, “If it sounds too good to be true, it probably is.” Many times, that’s exactly what this strategy will end up being.

Change of Heart

Fast forward a year and I receive a phone call from the man. He explains that he has now made the decision to come work with us instead. When I inquired about his sudden change of heart,  he told me it was because he didn’t make any money last year. I was shocked. After all, we were talking about 2016. The markets immediately demonstrated a remarkable run up following the election. When we met and I dug in for more information on how this was even possible, he told me that he had actually made -2% from June 2016 until the end of the year. I was beyond dumbstruck, to say the least.

Coincidentally, I had a client whose portfolio was very close in nature. It didn’t mirror the other man’s portfolio, however, it was extremely similar. The client that we had worked with in 2016  actually returned a significant % more. Again, while their portfolios differed slightly it was not by much. They both had comparable asset allocation models. So this other man with the seven-figure portfolio fell prey to the whims of active trading. He is a very knowledgeable investor and in his own words, “greed”, overwhelmed him.

Active trading is an enticing model. It promises investors the world, and while they may make some money the studies show the risks typically outweigh the benefits. One particular study conducted and published in 2000, Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. In the analysis, the authors, Brad Barber and Terrance Odean, found several correlations between active trading and poor performance for investors.

Barber and Odeon went on to publish another study into 2004 with several other colleagues that followed Taiwan day traders for a period of 14 years. What they found was that active trading typically caused 80% of those utilizing this strategy to lose money. Additionally, the study stated, “less than 1% of the total population of day traders is able to predictably and reliably earn positive abnormal returns net of fees.LESS THAN 1%!!!! That is within the margin of error of a variance. Which means it is entirely possible to have an error in that range.

Bottom Line

Here’s the bottom line. If building wealth is a goal for you then day trading is not for you. Despite all our technological advances, we do not have the expertise to outpace the market. You just can’t do it. Nonetheless, you will still often hear people brag about how they made money on a particular stock. Perhaps they’ll brag about how they knew it was the right time to buy or sell. Then the very next day when another stock fall and costs them money, they blame the markets. It’s very interesting. Watch people who brag about their great successes and then later wind about their failures one.

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