When I was an undergraduate studying finance, the idea of buying and selling common stocks sounded thrilling. It captivated me. I read accounts of day traders making millions, supposedly, by just sitting at their computers and buying low and selling high. How easy does that sound!? All I needed was a handful of well-placed trades each day and I was sure to be retired by age 30. Yet, as I delved deeper into the world of finance, and subsequently began my career as a professional portfolio manager, I learned those day trading stories were far from the reality of successful long-term investing.
If you want to be a successful investor for longer than a month or two and intend to trade every day, prepare to be disappointed. The odds are not in your favor. History shows that a clear majority of day traders fail to amass permanent wealth. In fact, roughly 95% of them actually lose money, according to a 2010 study by the University of California, Berkley.
One major reason for this failure is that anyone trading stocks must make two decisions and both must be correct, not just a time or two, but consistently over time. These are the buy decision and the sell decision (i.e., the roundtrip). This is a tall order, to say the least. In truth, no one can do this correctly consistently. Furthermore, the more attempts an active trader makes at being right twice, the higher the probability is that they will make a costly mistake that wipes out prior gains. In the end, it is a self-defeating exercise.
Most successful portfolio managers, by that I mean those that deliver stellar absolute and relative rates-of-return year-after-year, understand that no one is good enough to be right all the time. By accepting that, and not fighting it, they limit the number of times they must be right and in so doing, tilt the odds, or probabilities, in their favor. Consequently, trading only when necessary often becomes a point of pride with these investors.
Here’s how we maximize rate-of-return at MCM and how trading only when necessary supports our efforts:
We make well-informed initial “buy” decisions: Before purchasing a stock, our various research analyses must indicate that a company has the potential to deliver total rates-of-return (i.e., capital gains plus cash dividend) that meet or beat the broad market averages. If our analyses are correct, we are then able to hold a stock indefinitely…often for multi-year periods.
During this subsequent holding period, we practice a “buy-and-actively-manage” strategy that includes managing position sizes as the stock prices appreciate and regularly reassessing rate-of-return potential. It is not unusual for these stocks to double in value (e.g., 100% ROR!). Some even grow five or ten times their initial value to become what famed portfolio manager Peter Lynch dubbed a “tenbagger”.
Finding a tenbagger, or anything close to it, is hard work. Successful portfolio managers will be right in their investment decisions about 60-70% of the time. This average more than compensates for the 30-40% of the decisions that fail to meet expectations. This ratio of winners to losers helps minimize trade frequency since only the failures need to be replaced in the portfolio.
We minimize transaction costs: – Trading commissions range from a few dollars per trade to as much as $50 per trade. The costs can add up fast, even though trading commission have decreased substantially over the years. A high frequency trader will accumulate hundreds, even thousands, of dollars in trading commissions annually. This reoccurring expense decreases investment rate-of-return proportionally as every dollar paid in trading commissions is added to cost basis. To avoid eroding rate-of-return, it pays to trading commissions as low as possible. MCM does this by minimizing the raw number of trades executed and favoring transaction-fee-free investments whenever possible.
We employ tax-efficient strategies: – Frequent traders generate disproportionately large short-term capital gains which are taxed at the highest possible rate. Consequently, traders who are lucky enough to make money pre-tax end up surrendering a large portion of it to the IRS in taxes.
Alternatively, realized capital gains on securities held for more than one year are taxed at relatively favorable long-term rates. By holding investments until the IRS considers them long-term, MCM clients save thousands of dollars in taxes. This maximizes after-tax rate-of-return which is of paramount importance.
Better still, is if we can avoid taxes altogether, at least for a time. We do this by allowing unrealized capital gains to accumulate indefinitely in client portfolios. In so doing we defer the realization of capital gains as long as possible and the payment of capital gains taxes indefinitely…in many cases for years.
Successful investors focus on making sound investment decisions and then letting those decisions pay-off over long periods of time. In this way, investing successfully long-term does not look like what we see on CNBC every day. Most of those stories are about “where the action is”, which is designed for televisions ratings, not investment rate-of-return. Our advice is to leave the action for others who don’t know better and instead make great money for yourself.