How Wealth Is Generated Over The Long Haul
When I was studying to take my CFP® exam, I came across a stat from Dalton Education where they said that 90% of investing wealth comes from long-term investing.
Some strategies that help with being a long term investor come from the following:
- Dollar-Cost Averaging
- Picking a diversified asset allocation
- Have your financial goals written down, so you don’t get distracted from the noise and make too many changes to your portfolio that result in losses
These are not sexy things to do because they take a long time to implement. Suppose you ask someone if they would rather have $100 today or in one year $110. Most people will choose the $100 today because they get to benefit from using the money now. $10 is not life-changing to wait for, but it is still a ten percent return. If someone could maintain a 10% return in their retirement account for 40 years and contribute $100/mo, they would have $632,407 and invested $48,000. After staying the course for four decades, this is $584,407 worth of growth from the market.
What Is Required To Speed Up Wealth Creation
To get $632,407 in ten years, someone would need to average 139.58% per year and contribute $100/mo. However, the US stock market earned a 14.19% average over the last ten years, and the 15-years is 9.69% as of April 2022. To get an average return of 139.58%, someone would either need to:
- Find a significantly undervalued asset to buy
- Sticking with an asset with a lot of growth potential to invest in (Think buying Tesla or Bitcoin ten years ago)
- Become a day trader
For the first two options, there is a saying that you want to buy the rumor and sell the news. Once something becomes the news and is going to be a success, then a lot of the gains will already be realized. Buying the rumor requires you to have a lot of information about that industry and know its growth potential, but having this information doesn’t guarantee success.
To buy Bitcoin in 2011 was very hard because the technology wasn’t there to easily buy it and required someone to go through a lot of volatility to benefit from buying at $1 and selling at $60k a coin ten years later. All while not being distracted by all the other cryptocurrencies out there.
Doing day trading or speculative trades requires someone to guess how valuable something will be in the future and how much financial risk they want to accept when they make trades. So understanding systematic and unsystematic risks will be vital to someone’s success but doesn’t guarantee success as well.
How Being a Short Term Investor Is Difficult
There are about 19,063 different cryptocurrencies as of April 2022, and there are around 3,544 companies on the NASDAQ and around 2,400 on the NYSE. Someone would need to do a lot of research to know what investment will give them that annual 139.58% return and keep it a secret from the millions of other traders.
One of the concepts about taking on financial risk is that you need to be compensated for taking that risk. So if someone decides to buy a cryptocurrency or stock that had a lot of growth potential and didn’t work, they have to be okay with losing that money. When it comes to picking individual securities, there are no good trades without bad trades, and it’s part of the system.
So the route to get that 139.58% return would mainly require someone to become a day trader. The main goal of a day trader is to buy a security and then sell it for more than they bought it for and still make a profit after fees and taxes are subtracted.
Most day traders look at a candlestick chart which shows how the stock traded in the past, what was high and low for the day, and looking for patterns to see where to take advantage of the trading arbitrage. This is still a speculative strategy and according to trade city, only 7% of day traders remain in the game after five years.
I talked to someone last year, and he mentioned that he was a day trader and did well, but he also mentioned that day trading took up so much time because he had to research everything and was exhausted from it.
How Small Players In The Market Are At A Disadvantage
If you haven’t read the book Flash Boys by Michael Lewis, check out this 60-minute video to show how day traders are at a disadvantage against more technical operations. In the video, hedge funds and other institutional investors can see that you put in a market buy order for a block of shares for 50.01, but the other traders will see that trade and buy the block of shares before you and then sell them to you 50.03 since they got the price of 50.01 first.
The margins can be slim in day trading, but you can make up for this by going after volume with many trades. This front running of other investors is done in less than a second and can be replicated all day, but operational costs and taxes must be accounted for to ensure profit.
The trading platform, Robinhood, makes money by selling information about retail trades to hedge funds and institutional investors, so a small player using their platform to day trade can cause the purchase of trades to be higher and take away their profits.
Why Short Term Investors Are Still Needed
The safer investment strategy is to buy and hold for the long term, but the stock market needs day traders to create variation in the stock market. If everybody invested in a passive index fund, the stock market would go up and down based on the cash flow direction. With more dollars going into the stock market, the market goes up. When more money leaves than enters the stock market, the price of funds goes down.
When day traders make trades on individual stocks, you can see more defined valuations of respective companies, which will be reflected in the price of passive mutual funds and ETFs. It also allows underperforming companies to leave the market, be bought out by a competitor, or change their corporate strategy to create more value for shareholders.
Prices can be manipulated in the short run by day traders and not reflect the company’s actual valuation because speculation is baked into the price. Still, the speculation value can be realized, or it can evaporate. Eventually, time will tell folks what the proper valuation of the company was.
If you see somebody who made money from day trading, ask what the work and luck that happened to make this happen. Then ask yourself does it make sense for you to follow the same path. As always, just know the deal in fully before you accept the deal.
How Not To Be Taken Advantage Of
If someone is selling their trade secrets on how to make money in the stock market, then either it’s going to require a lot of work and research, or it is a trick that worked in the past but won’t work anymore or will soon be useless after enough people learn about the trick. Day trading is a challenging journey to take, and requires someone to have an advantage against all the other traders.
Take this story from a data scientist who decided to focus on horse races after leaving his job in investment banking. After first focusing on the size of horse nostrils to see if it led horses to win races, Jeff Seder eventually found out that horses with a large left ventricle had higher odds of winning. He could have kept this information to himself, but he gave that information away. Now horse betters have to look at other sources to see which horses will win. Breeders will probably start breeding for larger left ventricles in their horse’s hearts, and the betting odds for horses with larger left ventricles will be lower. So bettors will make less money on these horses because the bookkeepers are aware of this information and now can issue more beneficial odds for themselves. So if you have an advantage now in a competitive field, then it’s best to keep it a secret.
In economics, I learned that all profits go to zero in the long run, and it’s because of competition. There is competition in everything we do, and there are good things and bad things that come from the competition. With competition, we can get a lot of value creation which can help boost economic growth, which can help can benefit society and boost returns in the market. Someone that chooses to be a long term investor can benefit from this economic growth while not having to worry about competition from other traders.
With a lot of risks, there needs to be a potential reward for that risk, but make sure it is a calculated risk, and if someone decides to take that calculated risk, hopefully they can follow through on what they said they were going to do and were prepared for the setback that will come. Only 1.6% of day traders are profitable, and they make up 12% of the trading, so they’re making moves and spending most of their time on this skill. And if someone is not getting the results they want, it’s probably because they’re not following process or is proving more difficult than planned and should change their strategy.
The Choice Is Still Yours
Whatever choice someone makes with investing, it is best to know the deal before accepting the deal. There is no bad or good. It is just what it is. Life is risky, but you also want to manage that risk by ensuring you have a safety net and that one mistake will not wipe you out. If someone borrows $1 million to make a trade and earns 2%, they make $20k minus the interest. If they lost 2% off that $1 million borrowed money, they’re down $20k and still owe the lender $1 million-plus interest. If someone has $1 million in reserves, losing $20k might be one trade out of a 100, then the trader could still be ahead overall. If someone has a negative net worth, a $20k loss can cause pain.
Since 90% of investing wealth has come from long term investing, the more solid strategy is to buy and hold. Though, if you see someone make a lot of money on a meme stock or a cryptocurrency, then don’t let greed take over and make you think it is easy to do. It’s possible, but the probability of getting a 100% return in a year is extremely low. Most sustainable success comes from being a master in the domain, understanding the field you’re operating in, and knowing how to deal with competitors.
If someone wants to be speculative, then a barbell strategy could be useful. This technique involves having a portfolio where 90% is invested in financially stable securities, and 10% of the portfolio is invested in very speculative securities. I would tell people to read this Malcolm Gladwell article about Nassim Taleb to learn more about the barbell strategy. The biggest takeaway I got from Nassim Taleb was that you have to know how to bleed slowly to wait for that ample opportunity by minimizing your losses but exposing yourself to a huge upside.
Life is about choices, and we are the sum of those choices, so make sure you’re making the best choices with your life. Realize there will be losses in the short term, but to not make them permanent by learning from the failures and make different choices to get the outcome you want. Then ask yourself if you’re willing to make those choices.
It’s best not to compare your situation with someone else. Just focus on your effort and see if it will give you the life you want. If it’s not, then learn to change your choices when the cost is too great to bear. Chasing things can lead to a poor outcome if you think it will give you happiness and didn’t know the cost.
Disclaimer
This blog post is for educational purposes only. Please do your research or contact a professional before you make any changes to your financial situation.
Any links to third parties are not recommendations or endorsements and are for educational purposes.
