Why the Cards Are Stacked Against Traders

It's "Never Will I Ever" week on Industry Focus, and in this episode, Motley Fool analyst Vincent Shen is joined by senior Fool.com contributor Asit Sharma to lay out their bearish view of trading.

Many stock market enthusiasts have seen the studies pointing out the poor performance of day traders. But things like transaction costs and capital needs drive home the disadvantageous position speculators find themselves in -- tune in to learn more.

A full transcript follows the video.

This video was recorded on July 11, 2017.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. This is your host, Vincent Shen, and it's Tuesday July 11th. I'm happy to be back in the studio after the holiday last week, especially since we're continuing with our Never Will I Ever theme for Industry Focus this week. This is our opportunity to share some of the things that we want to avoid as much as possible for the sake of our investing and financial health. Joining me via Skype to share his take on "never will I ever" is senior Fool.com contributor Asit Sharma. Hey, Asit! It's great to have you with us.

Asit Sharma: Afternoon, Vince! Thanks very much!

Shen: Absolutely. You seemed really excited for this theme week, and you came up with some really good ideas with the core message and lessons behind this episode, so the least I can do is let you officially unveil it. What is, overall, our take on this Never Will I Ever theme? 

Sharma: Aside from, never will I ever eat as much dessert and sweet stuff as I did this weekend, something more stock and investment oriented, and that is never, ever will I trade. Folks, I have traded at various points in my checkered career. Most recently nine years ago. At that point, I decided, never, ever will I trade again. Vince, just curious, have you ever traded?

Shen: Here's the nuance, listeners, by the way, between trading and investing, trading being a much more short term focused endeavor. I've been fortunate enough to generally have avoided that. I've seen the losses stack up for friends and family who have tried the day trading game, and how poorly that ended up working out for them but fortunately seemed to learn their lessons relatively quickly. What was your experience like, Asit?

Sharma: I traded back in the early 90s for a bit. I traded stocks and I traded options, I've traded some futures, and I've traded foreign currencies, each time with a pretty small stake. At heart, I'm an investor. But like other people, I've been lured by this idea that I can take advantage of short-term price movements to increase your capital. It never quite worked out for me. This is why I'm so excited about this episode. Rather than give our listeners the generic reasons why you shouldn't trade -- it's risky, there are few people that succeed, sort of the things that you mentioned, Vince, which illustrate what we hear from family and friends when they try it, and personally, on my side, we wanted to give you some really specific reasons why the deck is stacked against you. And to do that, we're going to delve into the work of a very famous speculator today named Victor Niederhoffer. Victor Niederhoffer is one of the star futures traders, he's traded stocks, almost every conceivable market. And in the 80s, he became so renowned that legendary George Soros asked him to trade on his account. But he's also known for spectacular serial losings of fortunes, losing them, regaining them. He's an academic turned trader, so he provides a lot of great insights into trading. So we're going to talk about some bits from his memoir, The Education of a Speculator, which was published in 1998. A great read, I recommend any of our listeners, if you want to learn more about what speculation is like with some takeaways for investing, grab this book from Amazon. It's worth your time. It's very colorfully written, very well written. Niederhoffer gives some very tangible reasons why you shouldn't trade, and we're going to talk about those today.

Shen: Asit, when you first described this idea to me, I figured you were referring to the pretty well-known boogeyman of day trading, or technical trend trading, or whatever it might be. I think a lot of our Foolish investors and listeners are well aware of how often we hit here at the Fool on having a long-term outlook and investing horizon whenever possible. But there is more to this idea than just the common pitfalls, for people who measure their holding periods in just a few days or hours. We're going to look beyond some of the studies out there that indicate the large majority of day traders do end up underperforming the broad market and losing money, the fact that there's a lot of costs in transactions out there that end up erasing the profits. That's probably one of the first things that we're going to discuss. We're touching on two insights today from Victor. Can you kick us off on the first one?

Sharma: Absolutely. The first insight is, the bid-ask spread works against you in frequent trading. Vince, if I can ask you, for our listeners who don't know, to define what the bid-ask spread is, and then we'll tell you what Victor Niederhoffer's very particular take on this is.

Shen: Sure thing. For the bid-ask spread, you basically have two sides of the supply and demand equation. On the supply side, it's the asking price for the security, basically the minimum that someone is going to accept in order to sell. Then, you have the demand side of the equation, the bid, and that's the most someone is willing to pay in order to buy. The difference between them is the bid-ask spread. The reason this spread exists, just some background, is to compensate the market maker for the security. Just like it sounds, the market maker is usually a large brokerage or bank, and they take on risk by essentially holding an inventory of security, whether it's stock or options, and quickly fulfilling orders as they come through.

If you've ever wondered how it is that you can sell, for example, your 129 shares of company XYZ at the push of a button, those are not going directly to some buyer on the other side of the country or the globe, but the market maker picks them up. For more well-known, liquid stocks, for example, the spread is pretty small and pretty insignificant, since the market maker can quickly find buyers and sellers who are on the same page as to the value of each share. They might charge you one penny or two for the spread. But when you start getting into smaller and more obscure companies with less trading volume, you'll see the bid-ask spread widen, since the market maker will take on the shares you're selling and have to hold them potentially longer before finding a buyer. In the meantime, the value of that stock or security can change. The last thing they want to do is sell the shares at a lower price than they purchased them and rack up losses.

Sharma: Absolutely. That's a really great definition of the bid-ask spread and its implications. Victor Niederhoffer first observed this when he was a kid, hustling handball games on the streets of Brighton Beach. From an early age, he learned about how trading works by essentially being this kid gambler who was very good in handball. He went on to be a national squash champion, by the way, in his years at Harvard. But what Victor observed is that bookies would collect bets while he played. And what he tells us is, the bid-ask spread, what the market makers take in compensation for providing liquidity, is the same thing as the vigorish in the gambling world. The vigorish, or the vig, as it's more commonly known, is the commission that a bookie takes in order for you to place a bet. The ideal situation for a bookie is that he or she will collect equal bets from both sides of a wager on an event. That commission that he's charging each side is the bookie's vig, the vigorish. And Niederhoffer observes, in gambling, people get eaten up by the vig, but the same thing is true in the markets. You're essentially paying vig to the brokerage houses, or the market makers by extension, when you trade frequently. This has enormous implications for those who consider their transaction costs. 

I want to talk a little bit about the implication of size of the stock that you're trading, in terms of its total market capitalization. Vince, I know that you and I exchanged some notes. One of those was a slide by the famous finance and valuation expert at NYU, professor Aswath Damodaran. Professor Damodaran's slide in this particular study that we looked at showed that wider bid-ask spreads were associated with stocks that have a low market capitalization. For a high capitalization stock, those bid-ask spreads tend to narrow very much. So traders, there's some logic here that hit home to me when I was trading, that may be hitting home to you, if you're out there day trading. The stocks that you need to trade to make money in the stock market are the ones that are more volatile. And the ones that are more volatile, with the higher betas, those are smaller capitalization stocks for the most part. The biggest stock price movements during the day are correlated with stocks with low market capitalization. And professor Damodaran tells us, those have wide bid-ask spreads.

Let's move to a specific example. Vince, have you ever put on a pair of Uggs in your life?

Shen: Yes, I have tried a pair on. I've never owned them myself, but I have tried them on. They're pretty comfortable.

Sharma: Wonderful. We are, of course, referring to Deckers Outdoor Corporation. This is the maker of Ugg boots, which was a very popular item a few winters ago. The stock has been up and down. Vince, if I'm not mistaken, we currently have a buy recommendation on that stock at The Motley Fool, correct?

Shen: I believe so.

Sharma: So the Motley Fool is saying, "This is a long-term investment, in a Foolish way. Don't trade the stock, but buy it and hold it." A few specific technical things about this stock, how it trades on the market. If you go past recent history, its last few trading weeks, DECK, Deckers Outdoor Corporation, I'm just going to call it DECK for short, has a long-term beta of 2.0. That means it is twice as volatile as the market. And I checked the spreads on the stock this morning. The stock trades between $66 to $67, so let's just, for conversation's sake, say the stock trades around $67 right now. The bid-ask spread was fluctuating this morning anywhere from $0.03 to $0.12. So Vince, I'm going to ask you a question. Do you think that such a narrow spread -- let's take the middle of that, about $0.07 -- would have any impact on someone who traded the stock frequently?

Shen: Yeah, absolutely.

Sharma: That's why they pay you the big bucks, you have a lot of brain power. It took me losing money to figure this out in the markets. Let's take this example of $0.07. Investors out there who've dabbled in trading, assume that you're trading this stock, and you have stake of $6,700, that's 100 shares. And let's, to make the example simple, assume that your broker lets you trade on margin, which means you can trade the stock more than once a day. Let's say that you have two round trips a day. So, at a bid-ask spread of $0.07, that's the bid that you're giving up to the house, if you trade that stock two times a day, that's $14. That $14 multiplied by 250 trading days, assuming you're going to make good enough money to take two weeks off for vacation, that equals $3,500. So, we're talking about an initial stake of $6,700. More than half of that is just going to the vig, to the house, if you're trading the stock only twice a day. Now, let's talk about commissions. Those who trade often have probably researched, there are some brokerage houses, like interactive brokers, which only charge $1 per round trip. Four round trips in a day is $4 time 250, is another $1,000 on top of that $3,500. If you're going with the more traditional discount broker, even one that's only charging $5 a trade, that's $5,000 in commission, plus the $3,500 that you paid in vig. In one year, if your commission is $5, you will have $8,500 of trading costs on an initial trading stake of $6,700. So Vince, I'm going to flip it back to you and ask you to talk a little bit about the other side of that. What's the rationale to follow our investment advice, and invest in stocks versus trading?

Shen: That's the big thing here. The challenge for so many day traders, as you mentioned, you're looking for these stocks that will make significant short-term moves so that you can earn quick profits, but these are the very stocks that tend to have those larger bid-ask spreads. In this case, only $0.07 doesn't seem on the surface to be that much for Decker Outdoor. But having that larger spread means the smaller profits that you do make get eroded right off the bat by the higher cost. Whereas, in a situation where you're taking that longer-term outlook, as a Fool recommendation with this company, you buy it once, and regardless of what size your stake is, you buy it once and maybe you add on to your position a few times throughout the year, if you're trying to average out your cost. But in the end, you're only essentially paying that vig that you mentioned a handful of times versus dozens and dozens of times in a week or two-week period.

Sharma: Absolutely. So your money is really going to work for you, instead of being eroded by this frequent trading, which seems so innocuous unless you start paying attention to what it cost you in a year's worth of trading. And, by definition, day trading is, for many people, either a hobby or a career, and you're doing it frequently, you're doing it throughout the year, so you're turning to that capital. And that takes us to the second great insight that Niederhoffer makes in The Education of a Speculator.

Shen: That second piece of insight from Victor touches on how much you have to trade rather than the way you do it. Break it down for us, Asit, what is he talking about here?

Sharma: Niederhoffer says, without an adequate capital stake, the trader is doomed. That's my paraphrase of his point. Here's an example I'm going to read for our listeners which illustrates why trading stake size is important.

He says, "Consider playing the following game with the brokerage house. Each day, you flip a coin. If it comes up heads, you win $1. If it comes up tails, you lose $1. But on every toss, the broker takes out $0.20. What are the chances of ending a winner after 200 tosses? The answer -- about 1 in 100,000."

Now, the house's take is a function of this broker's commission that we've been talking about, the vig. And trading costs have decreased since The Education of a Speculator was published back in 1998. Also, Victor is probably referring here to futures contracts, which have a higher trading cost. All the same, you need an edge in trading. That means, statistically, you have to be right more than 50% of the time. So when you hear people talk about an edge, they're often not referring to a qualitative advantage, although that's wrapped up in it. More often, it refers to your statistical advantage each time you trade. Even with an edge of 60%, let's say you're right 60% of the time, without an adequate stake to suffer through the periods of losses, a trader is doomed. You have to have enough capital to weather those periods. And this, in the gambling world, is a well-known phenomenon called gambler's ruin. If you're a trader who thinks of yourself as a speculator, you're also exposed to this phenomenon. You have to have enough money to weather those storms. Vince, you and I talked about a really great scene from the movies, and that is in the movie The Sting starring Paul Newman and Robert Redford. Do you remember the scene that we're talking about?

Shen: There's a famous card playing scene on a train. Paul Newman, who's the main character, has to try and essentially cheat the cheaters at the table that he's playing with. Ultimately, it's a longer game, and the idea in The Sting is how Paul Newman's character, in order to be successful for himself in this game, has to sustain some of these ups and downs, to not only have the edge that you were referring to, but you have to have that adequate capital, in his case, having the money to put on the table.

Sharma: Yeah. It's a long trade. I really recommend this movie if you haven't seen The Sting. It's so great, and there's a lot to learn about life, and even the markets. Many great investing metaphors in it. It's a very tense scene, and it elapses time of a several hours long poker game. In order to have an adequate stake to cheat the bad guy, Paul Newman's accomplice earlier in the film actually steals the bad guy's wallet without his knowledge just before the poker game starts. But he needs that much, there's like $15,000 in the wallet, and he needs that much just to be able to get to the point at the very end of game where he can take the bad guy's money, which sets up a chain reaction of events which is pre-planned by Paul Newman's character and his accomplices to get back at this bad guy, whose name is Mr. Lonnegan. Without this adequate stake, he couldn't survive the poker game, and neither can you, listener. Neither can I. If you want to trade and learn how to speculate, don't go in with $1,000. You should have an adequate amount of money that you can afford to lose, and learn exactly what your edge is. Until you actually go through that, you actually don't know statistically how good you are against the markets. 

All this is leading up to our point that it's much better to invest. Now, what does investing have to do with trading in this example? Well, investing is agnostic to trade size. Vince, will it really matter if I have $1,000 if I invest versus $10,000, if I'm investing versus trading?

Shen: No, not a difference at all. And I think that's the big advantage that you have, taking this longer-term approach to it.

Sharma: Sure. We've been talking about, you and I, McDonald's, Starbucks, and Nike over the past year or so of doing these podcasts. I know we've talked about these stocks on several occasions. I pulled up some charts the other day, and looked at holding Starbucks and Nike and McDonald's, and the total return of holding those for just five years. And I found out that in each of those cases, even if you just had $1,000 and you put it into any of these stocks, you would have had over 100% return on your money. So, you would be doubling your money every five years. That's a very fast rate to double your capital. If you stretch that out to ten years for any of these stocks, it gets even more interesting. McDonald's, Starbucks, Nike, hold any of these for 10 years -- or, let's say you've held them for the last 10 years and invested the dividends, your return in each case would be at least 300%, which means you're making 30% on your money year after year after year. And that's extremely hard to replicate in a trading environment.

Shen: I think the big thing to point out there is, just the names that you mentioned, in terms of McDonald's, Starbucks, these aren't extremely risky companies in the tech sector or biotech or something where there might be a lot of volatility, or some decision, or a single year of growth that will send these stocks flying and then they might come back down. These are very stable businesses. In the end, in the consumer and retail sector that we talk about all the time here, companies like these can still provide really strong returns, if you invest and hold with that long-term perspective.

Sharma: Yeah. I would say the edge in this case is, the companies have the edge, you just have to find them. They're out there, they're big, they're ubiquitous, they have a market-leading, dominant position, and they're companies that have very strong fortress-like balance sheets and have shown this ability to grow year after year after year. That's why we love stocks like Starbucks, because they keep growing. They do the work for you, and the edge lies with them, not in your ability to determine, maybe if Starbucks is going to be up $0.50 in the next hour, should you buy it now and try to turn it around. Maybe it won't. Maybe it'll be down a week. But over the long-term, you're going to win if you can hang on and keep that stake invested.

Shen: That rounds out our never will I ever discussion for today. We hope you enjoyed getting a deeper understanding of why it can be so disadvantageous and difficult when you are trading versus investing. And for the second point, in terms of having that adequate capital, having that Sting example, I just remembered this, and I love this example, too. Just from Casino Royale -- big fan of the 007 films -- you think about the poker game from that movie where James, frankly, loses his pot in the first round, and eventually has to go to the CIA to get backed with another $10 million, but he's able to use that and come back and have that balance to eventually win against the villain in the movie.

For the rest of the week, make sure you turn in to the rest of Industry Focus. For Energy, you'll hear about commodities and pricing. On the Tech show, you'll find out why Dylan waits at least six months before buying into recently IPO'd companies. Thanks again, Asit, for joining us.

Sharma: Thank you, Vince.

Shen: And thanks everyone for listening. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!