APPENDIX: Why trading is unprofitable

A grade school level primer

Securities markets can be divided between primary markets where investors money goes into the treasuries of issuers and secondary markets where ownership of securities changes hands without new money provided to issuers.

Primary markets

Businesses raise money and invest it in hopefully profitable ventures. Profits are either reinvested or distributed to investors. Reinvestment produces growth. Successful issuers create value and investors benefit through their share of the value created, ultimately in the form of a growing stream of dividends or interest paid to them by the issuer over its life.

Businesses fail and limited liability caps the potential loss to investors at the amount they have invested in the case of corporations.

In United States, primary markets are governed by the 1933 Securities Act enforced by the federal Securities and Exchange Commission (SEC). In Canada, provincial Securities Acts govern initial and follow-on public offerings of securities.

Wealth accumulation results from careful selection of investments held for long periods. No other investment strategy will yield long term profits of any consequnce when investors are considered as a group.

Secondary markets

Investors trade securities of issuers which came into the market following an initial public offering or subsequent treasury issue. No new wealth is created, but some investors profit at the expense of others who lose money and the sell-side industry profits through fees and commissions which reduce returns to the owners of the businesses - the set of securities holders.

Secondary trading is governed in the United States by the 1934 Exchange Act and also regulated by the SEC. In Canada, provincial Securities Acts also regulate secondary markets. There is no federal securities law.

No investment strategy exists that will benefit investors as a group beyond the profits earned by the issuers less the commissions and transaction and advisory fees charged by market intermediaries. As a consequence, investors involved in secondary trading will as a group always suffer long term returns less than the returns on equity of the companies they own also treated as a group.

Intermediaries

Banks, brokers, advisors, portfolio managers and research analysts make up the majority of those employed as intermediaries, often referred to as the “sell-side” since their primary role is to persuade investors to trade securities on which they earn trading fees and commissions or to invest in mutual funds, ETF’s or hedge funds which they manage for fees sometimes including fees based on a percentage of “assets under management (AUM)”.

The sell-side creates no value and is parasitical to returns. Their success is persuading investors they have special skills or insights that will result in them producing returns greater than market averages and at the expense of investors who do not engage them to provide advice or manage their investments. As a set, they reduce returns to investors.

So-called “trading strategies” are advertising gimmicks that can only produce worse outcomes for investors as a set, with those who benefit more than offset by those who do not.

Secret to wealth accumulation

Investors wishing to accumulate wealth will more often than not succeed by investing in out of favor securities of well-managed and profitable companies growing more or less in line with or faster than the economy as a whole and who routinely pay investors a portion of their economic rents as interest or dividends, and holding these securities for long periods of time. All other strategies can only succeed for one investors at the expense of another investor who loses.