The world of investing has its own share of successful traders and successful investors. For examples the likes of Jesse Livermore, Stanley Druckenmiller, John Paulson and George Soros were extremely successful traders. At the same time, Warren Buffett, Charlie Munger and Peter Lynch have been extremely successful as investors committing their money from a longer time perspective. When we compare trading vs. investing returns, what turns out to be the better option? From the standpoint of someone participating in the stock markets, which is better trading or investing? Who makes more money traders or investors in the stock market? Let us first looking at trading versus investing..
Trading versus investing
While trading focuses more on riding the momentum of market, investing is all about long term value. There is the legendary story of how Rs.10,000 invested in Wipro in 1980 is worth Rs.547 crore in 2018. That is the kind of a perspective that a trader will never adopt. A trader looks to churn capital quickly and earn a series of small returns which will eventually compound into something large over a period of time. While both trading and investing have their pros and cons, let us understand how they compare in terms of performance using a simulated real life index situation.
The above chart displays the returns on the S&P 500 index over a 21 year period between 1996 and 2016. The first case scenario is when a person just puts the money in the index and forgets about it for 21 years. In the subsequent options, the individual takes a more strategic approach and tries to time the market by buying low and selling high. What are the findings? You will actually be surprised by the findings.
The truth is that over a 21 year period, the returns on trading are extremely dependent on how well you trade on the best and worst days in the market. In fact, if you had just missed the best 5 days over a 21 year period, your returns would have come down from 8.19% to 5.99%. Now over a period of 21 trading years there is a strong likelihood that you would miss the best trading days. That could actually mean your trading profits could be sharply compromised. There is worse to come. Had you missed the 30 best trading days you would have earned negative returns on trading stocks! The moral of the story is that practically it is very difficult for traders to outperform investors.
Why investments tend to outperform trading profits?
There are 5 reasons why investment returns tend to outperform investments..
Power of compounding works best in investing. What compounding means is that the longer you hold stocks the more it earns returns and therefore the more your returns earn returns. Since trading entails rapid churning of the funds and the portfolio, the scope for the power of compounding to work in your favour is quite limited.
Investing syncs with the longer tipping points of stocks. This is very important. Take the case of Infosys. Infosys started its business in the early 1980s but it was only after 16-18 years that the company could build a strong customer franchise, build economies of scale and create a profitable business model. Trading just cannot capture such a long outperformance cycle.
There is a transaction cost to trading. This is a very mundane issue but transaction costs can make a huge difference that these cost make when it comes to your effective returns. When you factor in brokerage, statutory costs and hidden costs like illiquidity and spread risks, the cost of trading is actually quite high. Investing is a lot more cost efficient compared to trading.
There is the tax impact on trading. When you trade you either show it as business income or you show it as short term capital gains. Either ways, you are taxed at your peak rate of tax, which is normally around 34.5% after factoring in surcharge. Long term capital gains are relatively more economical, even if you consider the recently introduced tax on LTC G.
Trading profits are very vulnerable to black swan events. We saw in the chart above how missing a few trading days can actually make a big difference to your trading performance. Then there are black swan events like a trade war or an event like the tech crash or event the sub-prime crash. These Black Swan events are large enough to wipe away years of performance.
How to mix the best of trading into investing..
Obviously, from a layman’s perspective, investing passively makes more sense since they may not have the wherewithal to predict these crests and troughs. The info-graphic below, which was conceived by Barclays to define the market cycles, perfectly captures the way investors and traders react to market stimuli. Quite often, individual investors and even institutional investors tend to become extremely euphoric at higher levels and overly pessimistic at lower levels. You end up buying in greed and selling in fear whereas you should actually be buying in fear and selling in greed. Obviously, that is easier said than done. What is a practical way to do it?
The crests and the troughs of the above chart best capture the P/E ratios of the index over a longer time frame. For example, the historical low P/E of the Nifty has been around 10 and the historic high has been around 28. Ideally, your investment strategy should incorporate a timing strategy wherein you aggressively shift into equities when the P/E of the market gets below 15 and start shifting to cash when P/E moves above 25. You may not perfectly time the market but you will at least be using a long term perspective of timing more effectively. Even if you can manage that, you are likely o be a classic outperformer in the market!