Why trading is a mug's game

And why buy and hold is a sensible tack to take

Secondary markets comprise a zero sum game where gains by one person come at the expense of another, except to the extent that the intrinsic value of the underlying businesses increases, which typically it does in line with economic growth. Sell-side brokers and analysts universally promote stocks based on the projection of higher prices, an odd phenomenon. If Mercedes offered new vehicles at a 50% discount their dealerships would be mobbed with buyers, but when stocks fall 50% people are jumping off buildings. Why is there such an obsession with stock prices?

In reality, lower stock prices benefit investors, giving them the opportunity to buy a larger share in an underlying business for less money. If the business is sound and continues to earn a return on capital employed consistent with its history and industry, buyers of the company’s shares will enjoy a growing stream of earnings and dividends over time. The only benefit of a higher trading price for the stock is if you sell and realize a gain. Then you are burdened with finding another company to invest the proceeds in at a price where you will enjoy returns at least as good as the ones you gave up by selling. That may be a challenging task and, as a class, investors will see the returns from the businesses underlying the set of stocks making up the total market suffer the parastical costs of brokers commissions, advisory fees, regulatory compliance costs and mutual fund fees and charges.

Based on the number of “hedge fund” managers and investment bankers who are billionaires or multi-millionaires it seems likely that trading stocks benefits them more than you. Higher stock prices increase fees based on “assets under management” and encourage trading which generates transaction fees for the intermediaries but does nothing to make the underlying businesses more profitable.

Choosing the right stocks can be difficult. A plethora of Nobel prize winners in economics and finance (Harry Markowitz, Merton Miller, Franco Modigliani, Eugene Fama, Fischer Black, Myron Scholes, James Merton, Robert Shiller, William Sharpe, Richard Thaler, to name a few) have all won renown by developing theories of market behaviour with differing conclusions:

• Many have won fame for the theory that markets are efficient (Markowitz, Miller, Modigliani, Fama and Sharpe) and support the Efficient Market Hypothesis (EMH) that at any point in time the trading price of a stock reasonably reflects its fair value within risk-reward space;

• Others have won fame for the theory that EMH is wrong and that it is possible to systematically outperform markets (Shiller) and that investor behaviour is irrational in that investors as a class over react to negative news and under-appreciate positive developments (Thaler);

• Black, Merton and Scholes gained renown for applying differential equations and a log-normal distribution of returns to option prices to develop a theory that the fair value of an option was the price at which the expected value of the risk of loss was equivalent to the expected value of the chances of gain during the option’s life.

Money managers either pay lip service to or ignore the advances arising from the work of these Nobel laureates, instead claiming they have special skill in choosing stocks. They use street jargon like “momentum, 50-day moving average, 200-day moving average, Bollinger bands, etc.” to persuade clients they have unique insights. However, 98% of money managers underperform the stock market averages. Pretty well all of them make a living, suggesting their spiel works for them if not for you.

What to do?

Investors lacking the education or skill to understand the economy, industry and prospects for any given company are driven into the hands of advisory firms. Money changes hands and the advisers buy big homes and fine cars while their clients typically receive less than market returns. The solution to this conundrum is index funds from reputable counterparties. The S&P Exchange Traded Fund tracks the Standard and Poor’s index of 500 stocks and has a very low expense ratio. Buy this ETF and your expected return will match the S&P index (but for those expenses which are nominal in context). Passive index investing is gaining in popularity for the reason that it produces better results for investors over time and does not victimize them with high fees, commission, and related costs.

Investors wanting a better outcome than the market should proceed with caution, but take heart from the fact that the return on capital employed for many listed companies exceeds the typical return on the market. For this reason, investors like Peter Lynch and Warren Buffett have systematically done better than the market by investing in companies they have analyzed in depth to confirm they produce reliable results that grow with the economy or better, then buying shares in those companies and keeping them. Their absence of frequent trading limits their exposure to fees and commissions and their long term outcomes parallel the success of their investee companies. They were and are wise buyers, often taking their positions when markets are weak owing to a weak macroeconomic environment or the company they choose is for the time being out of favor.

Lynch managed the legendary Magellan Fund of Fidelity Investments and turned in a compound annual rate of return of ~29% over the fund’s 14 year existence. Every penny of the fees paid to Lynch was money well spent. Buffett’s Berkshire Hathaway has generated wealth for shareholder for decades. His modest salary is well-earned.

We seem to be having a market sell-off right now, and may be heading into a recession. Companies with outstanding management in vital industries have fallen 20 to 30% in trading value in just a few months, and may tumble further if the recession materializes and takes hold. The long term profitability of those companies is not impaired by recession which only affects short term economics. That makes it likely that those who buy an index fund or pick away at solid companies currently out of favor during this market lull will enjoy good returns for years to come if they are wise enough to buy and hold their positions. What the Nobel laureates who promoted the EMH had right is the value of diversification. Not every company will succeed and owning solid companies in a diverse number of industries provides needed protection against adverse outcomes in one or two of the companies chosen.

I leave it to readers to decide what companies or what index funds fill the bill. Good luck with your investing.