Remember the day traders? It's hard to forget the late-90s stories of lawyers, doctors, accountants, and pizza delivery guys quitting their day jobs to trade stocks in the comfort of their living rooms. No boss, no deadlines, heck, no pants if you didn't feel like wearing 'em. It was the new American dream.
Like many, I assumed that the day traders disappeared when the Internet bubble burst, like Webvan, pets.com, and Ricky Martin. But apparently day trading is back -- and it's dumber than ever.
Image source: Getty Images.
Live and not learn
A recent article in The New York Times profiled Andy Lindloff and Steve Gomez, the owners of Today Trader, a 2-year-old Internet venture that enables subscribers to "look over the virtual shoulder" of day traders as they ply their trade in real time. Although Lindloff and Gomez have difficulty describing their investing strategy, they apparently have a knack for making money in the stock market. Lindloff claims that Gomez has averaged somewhere between $100,000 and $120,000 in annual trading profits over the past decade.
While that performance -- if true -- would certainly be impressive, it's hardly indicative of the typical day trader's experience. In a famous study of individual investors' behavior, professors Brad Barber and Terrance Odean found that the most active traders realized the lowest returns. In Barber's latest, yet-to-be-published study, he found that 80% of active traders lost money and "only 1% of them could be called predictably profitable." [Emphasis mine.]
That's because in addition to consistently picking winners, day traders must overcome two significant barriers: high short-term capital gains taxes and trading commissions. Assuming an average of 29 trades per day at $10 a pop, the typical day trader would have to make $72,500 per year just to break even!
In other words, day trading isn't gambling -- it's riskier than gambling. According to Barber's study, you'd have a better chance of making money (and probably have a lot more fun) by heading to the closest casino and playing roulette!
Stop me before I trade again
If they know the odds are so stacked against them, why do day traders keep trading?
As James Surowiecki opined back in 1999, "day trading is predicated on a fundamental misconception about the nature of stock prices, namely that they are somehow persistent and predictable. ... In order to succeed as a day trader over time," he continued, "you have to be one thing: incredibly lucky."
Take luck out of the equation
If you're not among that 1% of incredibly lucky traders, don't worry. Your odds of stock market success are actually quite good, as long as you're willing to measure success in terms of years, and not hours.
The fact is, over the short term -- a day, a week, a month, or even a year -- stock movements are random. But over the long run, stock prices tend to reflect the earnings power of the underlying business.
It is only over the long run that an investor's ability to assess the durability of a company's competitive advantages, the caliber of its management, and the extent of its growth prospects will truly bear fruit. Importantly, long-term-oriented investors also benefit from a lower tax rate and fewer commissions costs, which allows the power of compounding to work in their favor over time.
In other words, rather than worrying about where a company's share price is headed over the next five minutes, I encourage you to focus instead on where the company itself will be in five years.
Long-term investors don't waste their time speculating on the intraday movements of companies that might not even exist in five years, like Freddie Mac (NYSE: FRE) and Fannie Mae (NYSE: FNM). These failed financials are hemorrhaging money at an astonishing rate. Even if they manage to survive, there's a good chance that common shareholders will be massively diluted.
Similarly, long-term investors avoid companies with busted competitive strategies. At one point in time, Blockbuster (NYSE: BBI) and Borders Group (NYSE: BGP) enjoyed a barrier to entry against would-be rivals, thanks to their widespread store bases. However, nimble, capital-light, Internet-based businesses have turned those bricks-and-mortar stores into a strategic liability.
Long-term investors concentrate on companies with strong and sustainable economic moats that are likely to be bigger and better in five years. That's the strategy famously employed by Warren Buffett, and I'd say it's worked pretty well for him so far.
Three long-term winners
At Motley Fool Stock Advisor, David and Tom Gardner focus on companies with sustainable competitive advantages, strong financials, and shareholder-friendly management teams. Here are three companies the Motley Fool co-founders think will reward shareholders over the next five years:
- Activision Blizzard (Nasdaq: ATVI): This video game juggernaut boasts a stable of strong gaming franchises, including Call of Duty, Guitar Hero, and World of Warcraft, as well as a rock-solid balance sheet. Increasing consumer demand for digital content should only strengthen Activision Blizzard's industry-leading margins.
- Corrections Corp. (NYSE: CXW): The nation's largest private prison operator figures to benefit as its cash-strapped government customers seek more cost-effective solutions. Corrections Corp. can build prisons faster and operate them cheaper than its public peers.
- Hasbro (NYSE: HAS): Once a simple toymaker, Hasbro has transformed into a media powerhouse. The company has already enjoyed box office success with Transformers and G.I. Joe; its children's TV network will take center stage this fall.
If those sound like the types of companies you'd like to have carry your portfolio for the next five years (and beyond), click here to join Stock Advisor free for 30 days. You can read all of David's and Tom's recommendations, and see the rest of their best buys for new money now. There is no obligation to subscribe.
While Rich Greifner does not condone day trading, he does appreciate the allure of a pants-free lifestyle. Rich owns shares of Hasbro, Freddie Mac, and Fannie Mae (the latter two bought when he thought they had long-term competitive advantages). Activision Blizzard, Corrections Corporation of America, and Hasbro are Motley Fool Stock Advisor picks. Motley Fool Options has recommended a synthetic long position on Activision Blizzard. The Fool owns shares of Activision Blizzard and Hasbro. The Fool has a disclosure policy.
