Is Day Trading Worthwhile?
Every investor enters the equity markets with the goal of improving their net worth. Where to begin? There are countless strategies to attempt. Nowadays, greater numbers of individual investors are looking to “day trade” in hopes of gaining big profits. quickly. A simple internet search will uncover hundreds of instructional videos and websites boasting big gains via their “day trading” strategies.
So, is day trading a viable investing strategy? Or is “day trading” a here again, gone again fad (remember 2000) that is more harmful than it is helpful?
Let’s examine some widely accepted investing principles to help answer this question.
Numbers Don’t Lie: Too Good to Be True?
An old saying comes to mind: “If it sounds too good to be true, it probably is.” Day Trading is, at best, an unreliable, form of investing with payoffs that are more representative of gambling. At worst, it leads to huge financial losses and financial ruin.
“95% of all day traders fail” is a commonly used day trading statistic used online. But in reality, this number is considerably higher. Profitable day traders make up a very small proportion of all traders. Only 1.6% of all day traders are profitable in an average year.1
In addition, the average day trader performs much worse than the average individual investor. On average, individual investors underperform the market by 1.5%.2
Why is this the case? It all comes down to compound interest, fees and taxes, and the day traders’ underlying motives.
Albert Einstein once referred to compound interest as the eighth wonder of the world.3 He also said that those who understand compound interest earn it, while those who do not end up paying it.
Put simply, compound interest is the addition of interest to the principle of a loan or a deposit. In other words, it is the concept of earning interest on your interest. For instance, an investment with an annual rate of return of 7% will double in just over 10 years. When an investor uses the power of compound interest, that person earns exponentially more than their colleagues who do not.
This is the advantage of the stock market compared to banks and other financial instruments: Historically speaking, on average 10 years in the stock market will earn an investor more than 10 years in a bank. The stock market offers a higher rate of return (along with a higher level of risk). This is why time in the market is just as important as timing the market. While the stock market doesn’t always trend upward, in general, long-term investors can get a high rate of return even if they enter the market at an inopportune time. Time and the power of compound interest is on their side.
Day traders do not take advantage of this potent power of compound interest. They prefer to invest only one day at a time and only during open market hours. True day traders sell all of their stocks before the day’s end so they don’t get burned by any overnight or weekend drops in the market. Thus, day traders miss out on compound returns that can be created in “after-hours” trading prior to market open.
When an investor spends significant time in the market, transaction fees are less of a factor in their trades. For example, a portfolio manager who specializes in either buy-and-hold trading or market timing will lose less money to transaction fees compared to the average day trader.
Day traders, however, make dozens of transactions per week. Therefore, even if a day trader makes a profit on a trade, they will often lose most, or all, of their profit in transaction fees. Tax liabilities can also be an issue, but only if the day trader makes a profit.
Investing vs Gambling
While many investors face social pressures, no group of investors loses more money to social proofing than day traders. While the main motive behind market timing and buy-and-hold investing is to make a respectable return, the main motive behind day trading is to prove one’s greatness to other people. No group is more vocal about their investments and wins, than day traders.
If you’re skeptical, look at any trending stock that is up or down 10% or more on StockTwits. You will see comments like “Shorts getting crushed next round” from bullish traders and comments like “Bulls are running for cover” from bearish traders. Such comments show these traders seem oblivious to the risk of their trading habits. These investors are not just satisfied with making a profit, but they also derive satisfaction that someone else is losing because of their good fortune.
This is the underlying motive behind gambling: to get something out of nothing and to benefit from the misfortune of other people. Day trading is just as much about the thrill and the emotional aspects of trading as it is about the actual return.
This explains why so many people engage in day trading every year when only 1.6% of those people are able to turn a profit. There’s a much higher rate of success among different investment strategies. Day traders are more focused on proving their own abilities than they are focused on earning consistent equity like returns.
Much of this has to do with social proofing. Day trading has emerged as a “cool” trend in trading. Telling people that you make trades every day of the week in a high-stress environment is more interesting than telling people about your low-risk bond portfolio management. But, in the long run, that “boring” bond portfolio’s profits usually end up running circles around the vast majority of day traders’ profits.4
Expectations versus Reality
Most day traders have grandiose dreams of turning a huge fast profit in the market. Such people expect large net worth swings (or should), but they expect to be able to handle these risks while still living a comfortable lifestyle. This is not reality.
Nial Fuller of LearnToTradeTheMarket.com paints a much harsher picture of a day trader’s lifestyle. He says, “The reality of a day-trader is a guy who got 2 hours of sleep last night because he was trying to trade the overnight session, now he’s up at 6am trying to day-trade the next session. Many traders get sucked into trying to become a rich day-trader largely because that’s what they think is socially acceptable or ‘cool’, and it turns into them being glued to the charts every chance they get and probably not making much money (if any). This is not a healthy way to trade and it’s definitely not a healthy way to learn how to trade”.5
Bill Gunderson, a long-time investor and experienced money manager, has a rigorous criteria for entering a stock position: “Before I buy a stock, I want to see three things,” … “Value, performance, and a healthy stock chart. We follow 5000+ traded securities and we only invest in a very small portion of them. That means we have a lot to choose from and we have a very high bar.”6
Put simply, there are no shortcuts in investing. The overwhelming majority of day traders will end up with nothing but frustration and economic losses to show for their labors. If you are determined to day trade, be sure to set aside some money that you can afford to lose. Because chances are, it will be more of an education than a career. Thankfully there is value in education, but how much will it cost?
You Don’t Have to Invest Alone
There is risk in every type of investment. These risks may not be as high as the risks involved in day trading, but risk still intimidates many investors. This leads to what we call “paralysis by analysis”.
Fortunately, you are not alone in the world of investing. At Gunderson Capital, we are here to help you in your quest to achieve your financial goals. Chat with us about investing and our money management options.