Why most people should invest, not trade
Studies spanning decades keep reaching the same result: the more private investors trade, the worse they do. Doing nothing is an often underrated strategy there is.
Learning objective: After this lesson you can explain why frequent trading hurts most private investors.
There's hardly any field where more effort leads so often to worse results. If you trade a lot, you pay a lot of fees, make a lot of decisions and so get a lot of chances to be wrong.
The timing problem
Then there's timing. The best days on the stock market often come right after the worst. In March 2020 the market fell by about a third within a few weeks and then recovered faster than almost anyone expected. People who had sold out of fear missed the rise and got back in later at higher prices.
The savings plan as a fix
A savings plan solves the problem because it takes the decision away from you. It buys on the first of the month whether you feel good about it or not. That's boring, and that's exactly why it works.
A sensible middle path
If trading still appeals to you, there's a sensible way. Most of your money runs in the savings plan. A small part is play money you wouldn't mind losing. That way you learn without ruining yourself.
The best known study on this comes from Brad Barber and Terrance Odean. They analyzed the accounts of tens of thousands of customers of a large American discount broker. Those who traded most lagged clearly behind the market. The quietest accounts did best. The difference came mainly from trading costs and bad timing, less from the stocks bought being bad.
Fund return versus investor return
A second effect is the gap between a fund's return and its investors' return. The fund itself regularly does better than the people invested in it. That's because a lot of money flows in after strong rises and flows out again after declines. So investors tend to buy high and sell low, however good the product is.
The best trading days
On timing, there are analyses showing what happens if you miss just a few of the best days. A well known calculation by J.P. Morgan for the American S&P 500 from 2003 to 2022: anyone who missed only the ten best days in those twenty years ended up with roughly half as much as someone who simply stayed invested. The effect is so big because stock market gains are bunched into a few days. And those days fall especially often in the middle of uncertain phases, exactly when many investors have just got out.
Summary
- Private investors who trade more do worse on average.
- The best days often come right after the worst.
- A savings plan works because it takes the decision away from you.
Did you get it?
What did Barber and Odean find?
The investors who traded most did worst, the quietest did best.
What is the gap between funds and fund investors?
Investors earn less than their own fund because they buy after rises and sell after declines.
Why is getting out during a decline so expensive?
Because the strongest recovery days fall especially often in uncertain phases, when you're then not invested.
Your task
You trade with $5,000 and place 60 orders a year, each costing $3 including spread. Calculate the yearly cost in dollars and as a percent of the money. Compare it with an ETF at 0.2 percent per year and check the ETF part in the fee calculator ($5,000 starting capital, $0 monthly contribution, 7 percent return before costs, 1 year).
Sources and further reading
- Barber, B. M. and Odean, T. (2000), Trading Is Hazardous to Your Wealth, Journal of Finance View source ↗
Check your understanding
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- CommoditiesStage 1
- The savings planStage 2
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