Module 3: Establishing a sound long-term investment strategy | Blog 3-3: Market Timing and Day Trading by David S. Krause

Market timing and day trading have been discussed in several of the lessons I’ve presented within the course: Introduction to Applied Investing. These are two of the most controversial topics in all of investments. Can the stock market be timed and can an individual ‘beat’ the market by day trading? Here we’ll focus on the topic of day trading.

day tradingSome of my students initially find it objectionable that most of the investment text books have a negative view toward day trading – and refer to it as a loser’s (or negative sum) game.

For every successful trader that beats the market there will be unsuccessful ones that, on average, under-perform the overall market. Successful traders only exist at the expense of unsuccessful or below average market timers and traders. Clearly, it is impossible for everyone to be above average, so the entire lot of investors has to earn market performance, minus trading costs. Therefore it is mathematically impossible for there to be any more than a small number of investors to beat the market because trading is expensive – transactions costs and taxes are significant.

If trading didn’t cost anything, half of all traders would beat the index and half would lose (either that, or a few would make a lot and the majority would make only a little bit less than average); however, trading is very expensive. And the income tax system penalizes traders’ earnings with higher short-term capital gains taxes.  Not only does your chance of earning above average performance dramatically decrease when you trade, but when you get hammered with a high tax rate when you are successful, making it even harder to beat the market on a post-tax basis.

As I stated earlier, many students initially enter an investment program with the belief that they can outperform the market and have a high opinion of their trading abilities. But to the 10,000+ hedge funds and full-time professional traders and money managers, it is the millions of small traders out there that are the fodder. The unsophisticated individual day traders tend to get slaughtered!

Therefore, for a trader to do nothing more than simply match the after-tax return of an index fund, it is not sufficient to beat the market by a small amount, it is necessary to crush it. To beat the market after taxes and transactions costs, you must massively outperform the index.

So while you eventually learn that there is no Santa Claus, Easter Bunny or Tooth Fairy; it should also be obvious to most investors that you have little chance of beating the market by trading. The probability of you succeeding in this activity, to the extent of achieving the apparently modest goal of beating a market ETF investor after tax, is extremely low.

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