They say that the average person sleeps one-third of their life, what they fail to tell you is that if you live in Southern California (where I reside), another third is spent twiddling your thumbs in gridlock traffic. The unbeatable traffic at all hours of the day makes drivers day dream of becoming billionaires in order to buy private jets. Personally, I do not day dream about becoming a billionaire as much as I daydream about automated cars fixing traffic. However, until we get to that point there are some curious similarities between the way people drive and the way people invest. Whether it’s weaving in and out of traffic to get a slight edge on the rest of the crowd, or sitting in one lane for 312 miles behind the 83- year-old AARP recipient; there’s a type of investor that correlates to this driving behavior. Your goal as an investor should be to figure out exactly what type of behavior you display, that way you can master it and learn how to make it successful.
Case #1: The Traffic Weaver- Day Trader
The traffic weaver is the person that finds a way to drive 10 mph when the freeway is going 5 mph. This driver finds any opening, to the left or right lane, and darts for the opening, even if it only gives that person a minimal gain forward. You might be saying, “Well, that person going to get wherever they’re going faster, I could care less about cutting people off!” While this statement may be true (if you cut people off you are the reason my blood pressure if high at the ripe age of 22), they are also taking a lot more risk with all these extra moves they are making. Every weave in and out of traffic increases the risk of getting in an accident but it also gives the driver a better chance to get ahead than if they were just sitting in one lane. This is a classic example of risk vs. return, or to put it a different way, is all this extra risk worth the effort? This translates perfectly into the day trader. A day trader is a person who trades stocks, bonds, commodities, etc. dozens to hundreds of times a day in order to gain an advantage over the rest of investors. Similar to our traffic weaver jumping in and out of traffic, the day trader jumps in and out of whatever type of financial security they’re trading whenever they see an opportunity to make a quick profit. One of the ideas of day trading is to make a lot of small profits quickly and have those add up to a cumulative big profit. This is like making a lot of moves on the freeway to get you a little bit in front, and over a long road trip, it will get you to your destination a lot quicker.
This sounds like a wonderful idea so far, right? Without a doubt it does, but we have only touched on the return side of the coin. Of course, just like weaving in and out of traffic, day trading brings extra risk along with the potential for extra return. The reason why it brings extra risk is because day traders have to make a lot of decisions based on trends or opportunities they think they’re seeing. These decisions give them a lot of opportunities to gain an advantage, but they also give them a lot of opportunities to make mistakes. If a trader makes consistent mistakes while trading, the consequences can be severe and their returns can be well below the market’s returns. Obtaining below average returns is a bigger deal for a trader than a buy-and-hold investor because they’re putting in a lot of extra time and energy trying to maximize their returns. If the trader isn’t producing these returns then the opportunity cost of spending all that time trading is extremely counterproductive. This is similar to our traffic weaver if this person makes 200 lane switches only to get to his destination slower than the person who stayed in one lane; clearly, all that extra risk and effort was to no avail.
On top of making mistakes, each trade that a day trader makes costs a minimal amount of money to execute the trade. You may say, “Why would a minimal amount of money mean anything?” Gosh, you have the best questions! When you buy or sell a stock it will cost between $7-$10 to execute the trade, which isn’t much; however, if you make 150 trades in one day, you’re automatically in the hole for potentially $1500. Now imagine spending $1500 every day for each trading day of the year (around 252 days) which turns out to be $378,000 spent only on executing the trades! This is the same type of opportunity cost that a traffic weaver makes when accelerating and stopping a lot to get through traffic, every time they floor it in order to get a small advantage, they’re burning their gas faster which will end up costing more money over a long period of time. Of course, these are the repercussions of trying to gain an advantage over the other people participating; if there weren’t any drawbacks then a lot more people would do it because there would be less risk involved.
At this point, you might be thinking, “I would like day trading to get an advantage, there’s more opportunity to make money and I am okay with the cost of the trades, let's get started!” Well, not so fast my eager reader. Our traffic weaver will try to get ahead of traffic by cutting in and out of lanes and going way too fast when they get the opportunity to do so, this might get the attention of the cops. This is another tradeoff that the traffic weaver must deal with, they get to go faster, but at the risk of getting a ticket. The day trader faces a similar situation, not with the cops, but with taxes. If a person holds an investment for a year or more they get taxed at the capital gains tax rate. This is a huge incentive for most people to simply buy a stock and hold it for at least a year; because if you sell it within a year any gain that is made is taxed as ordinary income which will be a higher tax rate. This is similar to the traffic weaver’s case because both situations have systematic roadblocks that hold these strategies back and these roadblocks are incentives to follow the crowd (i.e. buying and holding).
Day trading is just one type of strategy that investors can use and it can be used with other types of strategies too. Some strategies investors may use is buying and holding, using leverage, and/or hedging with derivatives. Each of these strategies can be used together or separately within a portfolio. It is also important to understand the types of risks and the philosophies behind what you’re doing when investing your money. By understanding the philosophy behind your methods, you’ll be able to answer the “why” you’re making certain decisions with your money. This will allow you to survive and persevere when the market is turning against you and your methods because there will be solid logic behind your decisions. There are a lot of different strategies that investors can use, and investing is not a one size fits all situation. What works very well for some investors doesn’t work well for others, that’s why it is important to understand the different strategies out there and find what works for you. You wouldn’t change your driving style to a way that isn’t comfortable simply because other people drive that way, you drive the way that works for you. I challenge you to find an investment style that works for you too and learn to own it the same way you own cutting people off in dead-stop traffic.