Should You Trade Or Invest?

I often receive e-mails from potential traders that want to get “rich” trading. I tell them to instead consider investing their capital for long-term appreciation, preferably via passive or active mutual funds. This is why:

  • Most short-term traders end up losing money, not making money. If you invest in a mutual fund, you will almost guaranteed make money over a ten-year horizon (depending on valuations, of course). Let your money compound in a fund.
  • Short-term trading involves spending a lot of time trading and doing research. Trading is your job. Opposite, if you invest in mutual funds the capital works for you while you make money via a regular job.
  • Trading involves stress, both mentally and financially. Investing in a mutual fund does not involve much stress (buy it and forget it). Women are better investors than men, simply because they just buy and keep their mutual funds. Men have a stronger urge to outsmart the market, which usually fails.
  • You risk wasting you best years. Most traders are between 20 and 35, the years where you can improve your professional career. It’s not easy getting a job after 10 years as a trader, perhaps with mediocre results.
  • Most traders take a lot of risk, and just a few bad trades can ruin your finances.
  • In order to have trading as a job, you need to make more money than in a regular job to offset the risks.

There are an enormous amount of empirical evidence from online brokers indicating frequent traders under perform those buying and selling infrequent. In a recent study carried out by Charline Uhr, Andreas Hackethal and Steffen Meyer called Smoking Hot Portfolios? Self-Control and Investor Decisions, most of the above claims are empirically tested. The writers originally looked at the performance between smokers and non-smokers, but the takeaway is the following:

  • Smokers obtained better results than non-smokers.
  • Smokers were more diversified.
  • Smokers traded less frequent.
  • Smokers were less confident.

Why is this? As always with empirical research, we need to be cautious when making conclusions. Cause and effect are usually a bit more complicated than simple regressions indicate. However, the reason smokers fared better is that they as a group are well aware of their limitations (obviously smoking does not make you a better trader/investor). The authors conclude that when left to their own devices, smokers are worse investors than nonsmokers, because smokers lack self-control. Smokers are aware of their limitations and as a result of this they tend to seek advice, either via an advisor or they simply invest more often in mutual funds than non-smokers. Self-directed traders, more common among non-smokers, perform worse than funds, also very well documented in other research.

The above is why you should really think about your alternatives before you start to trade. Most short-term traders fail, while most unleveraged investors prosper.