The stock market increases in value on average 10% a year. Therefore, buying a stock at a low price now and selling it for profit later should be easy. Why then do 99% of day traders lose money? And the more active the trader, the worse his performance. Why is that?
A Common Trading Mindset
Bob is a stock trader. His strategy is to buy stocks when prices fall and sell them for a small profit on the rebound. He doesn’t want to be too greedy and risk losing money staying in any stock for too long. Any profit is a good result after all. Because he is patient, he can just wait for the next favorable opportunity to buy again.
AwesomeTech is a company that is steadily growing. Bob assumes that the optimal time to buy would be after a sharp price drop since the chance of it rebounding will be better than average. He’s not wrong.
Bob starts with $2000 in his account. His trades are shown below.
$2,000 - buy at $2, sell at $3 ($1,000 profit)
$3,000 - buy at $5, sell at $8 ($1,800 profit)
$4,800 - buy at $12, sell at $16 ($1,600 profit)
Bob executed his plan flawlessly. He locked in his profits as the price rose to avoid losing money. He then waited for the next significant price dip to buy again. He timed it perfectly, buying at the lowest point of each drop. In his mind, he bought low and sold high.
He made money with every trade netting 220% in total profit. Nevertheless, his results are actually terrible. We will break down what prevents his strategy from beating the index long term. Specifically, we will show why the more he trades, the less he makes, even when he executes his strategy almost perfectly.
The Logical Flaw In Timing Trades
There’s a huge flaw with trading the same stock over and over. If we pick an amazing stock that steadily gains value over time, the chance that the price will go up is higher than the chance it will go down. So every time we exit in the hopes of buying back at a lower price, we are taking a bet that’s worse than 50% odds that we are correct.
We only think we beat the odds because we occasionally do. It’s a confirmation bias. If we keep buying back the stock at higher prices than when we exited, then clearly we are wrong more often than we are right.
Nevertheless, that’s exactly what many traders are happily doing, repeatedly buying back in at higher prices. But how bad is it really if we are making a small profit with each trade? We will see that these seemingly safe trades carry a significant hidden risk.
The Risk Behind Active Trading
The risk for losing money is highest when we first enter a new stock position. If a stock drops to $15 after we bought it at $20, we have lost 25% of our value. But if we had stayed in the stock starting at $2, then even after a price drop from $20 to $15, we’re still up 650%.
Every time we re-enter at a higher price, we've missed all the profit that would have made our position safer. Specifically, we miss the profit from the point we exited our position until the point we re-enter. The risk for every stock goes up as its price increases. Therefore, by sitting out of a stock that we are willing to buy at an even higher price, we’ve increased our risk.
Notice that Bob only spent $2000 to buy 1000 shares at $2. But $4800 only bought 400 shares at $12. He bought a bigger position for far fewer shares with each subsequent trade.
Bob is correct to assume that chances are higher for a stock to rebound after a sharp price drop. But it’s only an increased chance, it’s not guaranteed. And that probability decreases as the price climbs higher.
It’s very possible to book many profitable trades for small gains at a low price and then wipe out much of those gains buying in at a high price. This is especially true since traders tend to hold their losses longer than their gains.
By settling for small profits when the stock is safest and risking big losses when the price becomes more dangerous, active traders handicap their own performance over the long run dipping in and out of stocks.
The Humongous Hidden Cost
Decreased purchasing power is a huge reason why many traders post low yearly returns. Yet, many are oblivious to its effect. The duration an active trader holds a stock is so brief that each missed opportunity doesn’t seem that much.
However, let’s suppose we sat on our $2000 initial investment at $2 versus Bob who bought back in again at $20.
$2000 buys 100 shares at $20.
$2000 buys 1000 shares at $2.
Let's ignore all our gains before $20 and only compare how much profit we will both make going forward.
The stock gained $10:
100 shares made $1,000 profit.
1000 shares made $10,000 profit.
The stock gained $100:
100 shares made $10,000 profit.
1000 shares made $100,000 profit.
The exact same amount of cash was used to buy both stock positions. However, the earlier investment made so much more profit in the future because the difference in shares are multiplied for every dollar gained. The results are staggering when we calculate how much value was actually lost by dipping in and out of the same stock.
At the stock price of $16, Bob made $4,400 total profit from his three trades. That gain seems amazing but it's not. If he left his investment alone, he would have made $14,000. And that gap in profits widens even more as the stock gains in value. His trades were mistakes regardless whether he made money.
The more often Bob trades good stocks, the less he will make compared to doing nothing. This correlation is corroborated by decades of real world data. Bob will underperform even when executing his buy-the-dip strategy almost flawlessly. But we will see that he will likely miss out on much more than that.
Holding vs Buying
Bob buys again at $20 with his entire account of $6,400. After the stock drops to $15, Bob decides to cut his losses. His total profit is now $2,800. Notice that it becomes increasingly tough to keep buying at higher prices. Suppose that the price then rallies up to $25 and then drops to $22. The risk for buying in at this price is even higher for Bob because he missed all the profits up until then. And at the higher prices, he is less sure that the stock will keep gaining.
Compare that to someone who bought in for $2 and left it alone until the current price of $22. This investor is up $20k with 1000 shares. There’s very little risk of losing money at this point. And the future gains are enormous since he has so many shares. He’s very comfortable with holding his position as long as he believes in the stock.
But Bob is only up $2,800 at this point. If he uses all his profits, he can only buy 127 shares at $22. If the price drops, it will significantly affect his returns. And even if the stock goes up, he will earn roughly one-eighth of what he would have if he had not exited. Therefore, after a certain point, the best decision is to just give up on this stock because the risk to reward ratio has become too high entering at the current price.
It becomes even more painful for Bob if the price keeps going up. Continuing to hold a position for a long time carries much less risk than reentering at a higher price. Therefore, Bob will likely exit for the last time much earlier than an investor who held since $2. Bob picked an amazing stock but got mediocre results and eventually had to give up on the stock before he saw extraordinary gains.
He achieved a disappointing outcome even with an astonishingly profitable stock. Now, consider a typical portfolio having mediocre and poor performing stocks in the mix. Furthermore, note that Bob will not time his purchases nearly as well as he had in the example.
If traders do not make much money on their best stock picks and lose money on their bad picks, it’s not surprising that the majority of them perform so poorly. Finding one or two stocks each year that are massively undervalued is phenomenal. Jumping from one stock to another hoping to find the same amazing gain on the regular basis is a pipe dream.
Costly Tax Consideration
We pay roughly twice as much in taxes for trading stocks vs holding it for more than a year. That extra amount paid when compounded over the years, is absolutely enormous. In addition, the more we trade, the more transaction costs we pay. The total cost of active trading could be the biggest performance difference between trading vs investing for many people.
Suppose we pay $6k more in taxes and fees each year because of active trading. Over 40 years, that extra $250k in total principal becomes a difference of $3 million dollars in missed profit by simply assuming a 10% index average.
My Own Experience
I knew very little about investing when I first started buying stocks. Bob might as well be a stand in for Binh. Everything Bob did and thought, I had done. I'm not the only one. There are plenty of videos in which people explained the same type of trading strategy described in my example. Many of them with 95% thumbs up. This strategy of buying the dip seems plausible but it is seriously misguided in the crucial points I’ve explained in this article. It does not work. It severely underperforms.
I’ve gained these insights after making lots of mistakes and critically evaluating all the reasons why I made them. By jumping in and out of stocks, I made very little money even when the stocks skyrocketed. And I had no idea when to cut my losses when my bad stock picks kept crashing. That’s because as a stock trader, I was focused on the price movements itself and not the underlying reasons why I should hold a stock.
A stock investor is not a stock trader. An investor compares the price of the stock to the value he believes for the company. He doesn’t care about the price fluctuation that traders fixate on. That’s why he is able to capture the big long term gains. My performance dramatically improved only once I stopped trading and started investing. The facts support my case as well as for many others.
A stock trader may think buying low and selling high means buying the short term dip and locking in small profits. But that’s a horrible shortsighted strategy.
Many traders are unaware of their poor performance because what they give up is often opportunity cost and that doesn't show up in their profits and losses for individual trades. But their performance over the years is often subpar because of it. History has shown that active traders perform very poorly versus investors in the long run.
For an investor, buying low and selling high means buying a stock that he believes is undervalued and selling it once the price exceeds his expectations. The big difference is that an investor makes his decisions based on his underlying valuation for the company whereas a trader makes his decisions based on the price movements themselves.
Based on his valuation, an investor may trim his position when he deems a stock price has become too expensive. He may also repurchase the stock if the price drops to a level he believes is cheap. However, buying and selling the same stock happens organically. He does not try to time his trades in an attempt to profit from short term price fluctuations.
Regardless, investors are also not immune to bad decision making and flawed strategies. Therefore, all investors and traders should look at their own returns over a long span of many years and evaluate it critically. If they are not outperforming the index consistently over a very long time, it’s not from bad luck. Their overall strategy is not working.