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3 Facts of Life Short-Term Traders Need to Accept

By Alex Dumortier, CFA, Dan Caplinger, and Jordan Wathen - Updated Oct 9, 2018 at 3:06PM

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Trading is a tough way to earn a return. Here are three reasons why that's the case.

At The Motley Fool, we believe long-term investing is the optimal path to building wealth. However, if you are considering short-term trading as an alternative strategy, I recommend you do so only with a full appreciation of the challenges and risks that are involved. Here are three facts that short-term traders need to accept:

Alex Dumortier: Short-term trading is a zero-sum game -- and that's before accounting for costs. That's a fact. In order for you to make money that way, someone needs to lose money. But note that this "one-for-one" expression for a zero-sum game does not adequately convey how the odds are stacked against traders. Winners and losers are not equally distributed.

Dice labeled BUY and SELL on top of LCD screen showing stock charts

Image source: Getty Images.

In a 2004 paper, four researchers based in California and Taiwan examined the record of Taiwan's massive day-trading community. While they found "strong evidence of persistent ability for a relatively small group of day traders," they also concluded that:

Heavy day traders earn gross profits, but their profits are not sufficient to cover transaction costs. Moreover, in the typical six month period, more than eight out of ten day traders lose money.

In aggregate, the economic cost of trading can be staggering. Following up with a paper in 2009, the same authors conclude:

Individual investor trading results in systematic and economically large losses. Using a complete trading history of all investors in Taiwan, we document that the aggregate portfolio of individuals suffers an annual performance penalty of 3.8 percentage points.

Let me reiterate that number: 3.8 percentage points... annually. Talk about hamstringing yourself! In order to be a (successful) trader, you need to be able to consistently beat most of your peers. If you can't do that, the penalty is enormous. For virtually all individual investors, not trying to beat anyone -- by investing in index funds -- is an easier route to better returns.

Jordan Wathen: Legendary investor Ben Graham once wrote that "In the short run, the market is a voting machine but in the long run, it is a weighing machine."

That is to say that stock prices are guided by popular opinion in the short term, but over the long haul, performance is much more precise. A good stock will have its bad days, weeks, and even years, but in the long haul, its performance will closely match the performance of the business.

Taking short-term positions in stocks may be the most difficult method for making money in the stock market. Sure, the rewards are huge -- you can make a lot of money very quickly by getting the market's reaction to earnings reports right. But doing so is almost impossible to do repeatedly. You'll have to predict the reaction of emotional people making emotional decisions about a company based on a few data points.

It is much easier -- and financially more rewarding, according to piles of studies on investor behavior -- to simply buy stocks you like and hold them for the long term. Almost universally, more activity leads to worse investor performance.

Dan Caplinger: One consequence of short-term trading that many people ignore is the fact that even if you're successful in picking winners consistently, Uncle Sam will take a bigger bite of your gains in the form of taxes. Capital gains on investment sales have much different tax rates depending on how long you've held a particular investment, and getting preferential treatment requires owning a stock or other investment for longer than a full year.

The impact of higher tax rates is larger than many people realize. Short-term capital gains get taxed at your ordinary income tax rate, which can be as high as 39.6%. State taxes can add even higher taxes on gains. By contrast, long-term capital gains rates max out at 20% for those in the top tax bracket, and for those who pay most federal taxes at 10% or 15%, long-term capital gains incur no tax at all. Even for those who pay 25% to 35% tax rates ordinarily, the savings from the lower 15% capital gains rate that applies can be substantial.

Taxes aren't the only factor in investing decisions. But if you plan to trade routinely rather than holding stocks for the long run, you'll miss out on some of the biggest tax advantages that long-term investors enjoy.

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