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Even Day Traders Recommend Index Funds

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That’s right! A guy who actively buys and sells stocks is suggesting you should stick with Plain Jane index funds.

Why?

Because it’s too difficult for 99% (a completely unscientific statistic) of the general public to outperform the market over an extended period of time.

Every week, at least one person will ask me for a hot stock tip. Almost every single time, I tell them to buy a basic Vanguard S&P 500 index fund. If they keep up the pressure and want something more aggressive, I tell them to buy the Vanguard Small-Cap Index Fund which passively invests in smaller, higher growth, but higher risk companies.

Now, before the pro-index fund, Boglehead crowd showers me with kudos and the pro-trader crowd throws flaming bags of dog crap on my porch, allow me a few moments to debunk the Get Rich Quick by Becoming an Active Trader myth.

  1. Successful investing requires counter intuitive human emotions. The best time to buy stocks is when everyone is scared senseless, and the best time to sell is during a period of irrational exuberance. In other words, you must have the courage to go against the herd at all times. So if listening to the doom & gloom news scared you so severely that you sold your stocks in February 2009 only to buy them back in May 2009 (at a higher price), then trading isn’t for you.
  2. You don’t follow the stock market nearly enough. I often compare active trading to having seats along the first or third base line. You have an excellent view of the game, but if you aren’t paying attention to every single pitch during that game, a sharply hit foul ball can ruin your day in less than a second. Same goes with being an active trader. You must follow the market on a daily — if not a minute by minute — basis. If you can’t devote the time and attention the market requires, find yourself a safer place to sit.
  3. Traders that appear on CNBC aren’t that different than Billy Mays. A trader’s job is to make money. Period. To do so, some traders don’t mind becoming “pitchmen” and letting you know their stock picks are greatest thing since sliced bread. Shortly thereafter (often without a second CNBC appearance), those same traders will begin cashing in profits if their stocks increase in value. They’ll sell half their positions at a 10% profit (or some arbitrary profit point), and let the rest ride until they don’t expect any further price appreciation.
  4. You don’t know when to sell. We are constantly bombarded with tons of research on why you should buy a stock, but rarely are you told why (or when) to sell. Until you sell a stock, you’re holding onto nothing but unrealized gains (assuming you’re not in the red). Depending upon your trading discipline, knowing when to sell a stock is just as important, if not more important, than knowing which stocks to buy.
  5. Having the tools isn’t enough. Just because you have a hammer, a set of blueprints and hundreds of 2x4s, it doesn’t mean you’re ready to build a house. The same goes with trading once you assemble an active traders tool kit. Discount brokers might try to convince you that trading is so easy even a talking baby can do it (e.g. the hilarious E*Trade baby commercials), but it doesn’t mean everyone can do it successfully right out of the gate. Take a lesson from gold rush history, where the people who had the best chance of making money were the store owners that sold tools to the gold miners, not the miners digging for gold.
  6. How much is your time worth versus outperforming the market. Active investing requires a huge time investment. Researching the fundamentals, reviewing stock charts, etc., can easily be equivalent to having a full time job. As The Simple Dollar points out, even if you have the skill to outperform the S&P 500 by just 1%, your hourly wage for a 25 hour work week over last 10 years would be a pathetic $0.77 per hour. Even when you extend the 1% out-performance ratio over a 30 year time horizon, you get a paltry minimum wage salary of just $7.34 per hour. Hardly worth the time investment unless you consider trading to be some sort of personal hobby or equate trading to a no-limits game of Texas Holdem.

Bottom line is that you can probably find better, more profitable things to do with your time. So save yourself the time investment and the money you’ll likely waste on trading commissions. Find something more worthwhile to occupy your entrepreneurial spirit because goodness knows being a full time trader isn’t exactly a fulfilling career.

And if my reasoning has failed to convince you, maybe some sage advice from the world’s most famous and articulate investor (Warren Buffett) can change your mind. If not, then best of luck to you.

This is a guest post by Matt SF at Steadfast Finances.

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6 Responses to “Even Day Traders Recommend Index Funds”

  1. This was really really good.

  2. ctreit says:

    This is a very insightful post. When you invest for the long haul, using cheap investing vehicles is a good way to perform well. Index funds and ETFs allow the average investor to invest in financial markets on the cheap without exerting much effort studying the market or individual stocks. Many studies have also shown that timing the market, i.e. picking the times when the market or stocks turn upwards or downwards, does not work for most investors in the long run.

  3. eric says:

    Well I feel even better about myself now. :)

  4. Great post. I keep telling my dad to get into index funds but he likes the risk of single stocks.

  5. Matt SF says:

    Thanks for the comments gents. I’m guilty of trader heresy for saying it, and will probably never get E*trade or TD Ameritrade to sponsor my blog, but in my humble opinion, index funds are the way to go for the vast majority of investors.

  6. Most people would do well to heed this advice . . . but many won’t.


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