There are multiple ways of creating wealth in stock markets. On one side there are intra day traders and traders doing BTST operations (buy today sell tomorrow) fully resourced by their brokers giving them trading tips – just like the talking hosts on tv – and at the other extreme there are investors which don’t mind buying and literally forgetting holding their stocks for years if not decades.
And given that many variations of these – depending upon where do they fall in between the above two extremes – are being followed in the market generally by the masses one can say that people find some utility in these (or at least they so perceive:) )
Which approach should one follow?
Just like in other aspects of our lives, the chosen path should be the one which is walk able (or practical to follow) given that one needs to continue his stride for fairly long time in order to reach his end goal and also the one which promises the fulfilment of the goals which the traveller initially looked up upon before starting to march. In other words, it should something which doesn’t burnout its followers – or else they wouldn’t live to travel the course – and should also be rewarding in the end.
Let’s explore both of these extremes (trading and long term investing) further and try to make sense of each of these:
Trading is simulating. It requires information to act upon, involves frequent decision making, has high transaction cost, is tax inefficient, has excess diversification involved and is mentally stressful
(i) Information: Generally, a trader is constantly looking for information upon which he can immediately act and profit. As such, it wouldn’t be wrong to say that after a while he becomes addicted to information streams. And combine this addiction with today’s 24×7 connected world which means that somewhere there is an information overload. Research tells us that as information increases, decision making ability deteriorates. Beyond a point, soaking information only makes things worse. Today, information is commodity and ability to filter it through and separating knowledge from noise is the chief task which a decision maker faces. It wouldn’t be wrong to say that today, given the information overload in some form or other, odds are stacked against the trader as increasing information only impedes decision making.
(ii) Frequent decision making: Traders need to make decisions several times a day, every day and we know that when the frequency of making decisions goes up, so does the error of commission. Taking a hypothetical example assuming that if both a long term investor and a trader were to earn 15% in a year, the number of decisions taken by the trader to earn that return would be way higher versus that of an investor.
(iii) Transaction costs: As the frequency of buying & selling stocks is high, transactions cost are also high. It ends up taking a toll on the returns one earns during the year. When it comes to compounding money over long periods of time – which is what our discussion is all about – such differences end up being significant in absolute terms. 100,000 compounded at 18% for 20 years is 35,60,000 and that at 16.5% for 20 years is 26,50,000. Every percentage point counts when it comes to investing.
(iv) Taxes: With frequent buying selling comes the need to pay taxes regularly. And generally short term tax rates are much higher than long term tax rates and in India currently, returns from long term investments in equities (>1 yr) are exempt . Also, we know that even if tax rates were to similar the fact that tax deferrals add value to an investor’s portfolio should not be forgotten.
(v) Excess Diversification: As a capital market participant some diversification is valuable but beyond a point (say >20 or 30 stocks) it starts adding negative value to the portfolio. Difference in weights between the hits & misses narrows. Remember, what matters over time is how much money you make when you are right and how much you lose if your wrong. When it comes to traders, things are even worse since generally they prefer to trade simultaneously in many ideas due to which they are unable to build worthwhile position (say >5-7%) in any investments.
(vi) Addiction to stock quotes: If you want to make a trader’s day worse, just cut him off from checking stock prices during market hours 🙂 . He would crave for have just one look.
(vii) Mental Fatigue: Given the need to take frequent decisions, gulping in information in huge doses everyday, constant hunt for news flow, etc takes toll on physical and mental health of a trader. It is not unheard of young guys below the age of 40 dying in this industry due to heart attack. For compounding to work its magic, you need to be here not for a couple of years but decades all together.
It is clear that odds are stacked against a day trader when it comes to compounding money & wealth creation over a longer period of time. As the saying goes, activity is the enemy of an investor.
Long Term Investors / Business Owners
As against traders, long term investors enjoy several advantages. They can concentrate their holdings, take advantage of – as Benjamin Graham said – other person’s follies given their longer term horizon, save on transactions costs & taxes, retain their ability to separate knowledge from noise by avoiding information over dose and do all this while living a fulfilling life!
(i) Concentrated Portfolios: In markets, one is paid for his conviction. By investing in businesses which one understands and not over paying for the same, one can turn odds in his favour. When one starts to see a business from the eyes of the business owners while taking a longer term outlook, ability to take concentrated bets increases (say <15 or 20 stocks in a portfolio). This bodes well for a truly long term, value oriented investor
(ii) Taking advantage of market follies: As Graham once said ‘Market is like a voting machine is short term and weighing machine in longer term’. Market is known to be inefficient over long term (3 to 5 yrs) and this is precisely where the advantage of a long term investor lies
(iii) Save on costs & taxes: Since buying selling decisions undertaken by an investor is less versus a trader, he saves on transaction costs. Also, tax benefits derived by it over long periods could add up to be significant. Consider this, if an investor is holding just 10-12 stocks in his portfolio and has a holding period, on average, of 3 years. It means that he needs to find just 3 or 4 stocks every year to buy & replace the existing ones!
(iv) Avoid information overload: Unlike a trader, an investor who thinks & acts like a business owner is under no obligation to read every new bit of information which comes across relating to the companies he owns. He enjoys this luxury due to his understanding of the business, longer term outlook and owner like attitude. In the end, odds are better placed for him to enable him to make better decisions since he never bombards himself with excess information dosage.
To sum-up, when it comes to compounding duration matters. One needs to find an approach which is something that can be almost religiously followed not just for years but for decades. While trading is tiring and in itself a ‘negative feedback loop’, long term investing is exact opposite of this. This is not to say investing is easy. Far from that. But it is simple and one just need not complicate it.
Cheers and happy diwali. Have a safe one 🙂