Charlie Munger likes to invert problems.
He says he’d like to know where he is destined to die. Why?
“So I can then be sure never to go there”.
Similarly, one way to get rich is to think about how to get poor…..and then do the opposite. A good example of this is day trading.
When I told people I was leaving my job, they asked what I was doing next. Some people (who knew I was into investing) asked whether I’d be spending my time day trading?
Errrr…no. I didn’t spend 20 years in the office staring at numbers on a screen just so I could spend the next 20 years at home staring at numbers on a screen. Like Julia Roberts said in Pretty Woman: that’s not changing your life, that’s just geography.
Day trading is not a great way to spend your time but it is an effective way to lose money. The best way to make a small fortune day trading is to start with a large fortune.
People often think of buying shares like its gambling. And in a way it is. But it depends which side of the table you’re sitting. There is a huge difference between gambling if you are the casino and gambling if you are a customer of the casino.
Let’s visualise the customer. Frankie Fuckwit is 26 and is on a stag do in Las Vegas. He has white sneakers, a baseball cap on backwards and a T-Shirt that says “Instant Asshole…just add alcohol“. Frankie has many flaws, but he does have some self-awareness.
Having already added alcohol into the proceedings, Frankie & Co. decide to go and play roulette. If you own the casino, this situation is shaping up nicely for you.
The casino owner doesn’t really care if the next spin comes up red or black. Win some, lose some. You just want lots of Frankies in the casino betting on as many spins of the roulette wheel as possible.
That’s because the casino has an Edge. This is an important concept: an edge is an inbuilt advantage that tilts the odds in your favour (if you own the casino) or against you (if you’re Frankie).
In roulette, the casino’s Edge is provided by the zero(s) on the wheel. Imagine a roulette wheel with 37 slots – 36 numbers and a zero.
If you are betting on Red or Black, you lose if the ball lands on the (green) zero. So if you bet £100 on Red your payoffs are to win £200 18 times out of 37 and to lose £100 19 time out of 37. The expected return on a £100 bet is £97.3*. So the playing field is tilted in favour of the casino and the £2.70 difference is the casino’s Edge.
To demonstrate the house Edge, imagine placing £1 bets on all the numbers (including 0) to assure a win: you would only get back £36, having spent £37. That’s a bad trade.
So in almost everything in life, I think about whether I am the casino or whether I am Frankie. As Warren Buffett says, if you are at the poker table and you don’t know who the patsy is, then it’s probably you.
- If you are a day trader, your stockbroker or spread betting account provider is the casino and you are Frankie. The broker’s edge is the dealing costs (bid-offer spreads, commissions, fees).
- If you are a customer of a Wealth Manager, typically paying 2.0 – 2.5% of funds under management per year in total costs, the Wealth Manager is the casino and you are Frankie.
- If you are a customer of a pay-day loan provider, you are most definitely Frankie and the casino is the lender.
- If you in a bar buying Jaegerbombs, you are Frankie and the bar and the drinks companies are running the casino.
- If you decide to get divorced and you go to see a lawyer, be careful. You are auditioning for the role of Frankie – the casino role has already been filled by the law firm.
I could go on…
There is an endless supply of Frankies created every day. Because there are so many Frankies, there will always be people scalping them via fees and commissions, “learn to trade” courses, timeshare sales pitches and other assorted get rich quick schemes.
So if you see a tip, a website or something else that involves day trading or any form of short-term speculation, I suggest you run away like Usain Bolt being chased with someone with Ebola.
There is however an easy way to give yourself an Edge (and be like the casino). That it to invest in equities for the long-term using a global tracker fund bought via a low cost execution only online broker. As a long-term owner of equities, your Edge is the 5 or 6% annual earnings growth that quoted companies have tended to punch out over the last 100 years or so.
Once you have bought your tracker fund, the ideal holding period is for ever. Every time you trade, the broker takes a slice of your pie (in the form of dealing commission). Investing is different to other areas of life because inactivity is positively rewarded.
Long term equity ownership is like owning the casino – sure, there are wins and losses each time the wheel is spun. But over the long-term, the game is stacked in your favour. This is because you are not gambling on the value of a number on a screen or a plastic chip. Instead you are acquiring a stake in productive assets (capital, labour, technology) and human progress.
Think about equities as your stake in factories, fork lift trucks, production lines, new technology and hard-working employees. When I go to sleep, I find it reassuring to envisage the night shift running at my companies – they are working hard for me while I am pushing out zzz’s.
If you take a long view, betting in favour of human progress has always been the right thing to do.
To visualise human progress, behold the riches that capitalism has delivered. Take a boat trip into Venice, down the Thames or look at the Manhattan skyline from the Statue of Liberty and marvel on what we created. You have to admire the ambition, the architecture and the construction, even if not the use to which the buildings are put.
The reason the stock market goes up most years is not that the Fed was easing, there was a head and shoulders formation or some other voodoo witchcraft. The reason the market tends to go up is simple. The aggregate profits, cashflows and dividends of the underlying companies in the index go up most years. Yes, there are sometimes multi-year bear markets, but on a long view these are just blips on a relentless upward path.
If you can understand the Edge that the casino has over Frankie, you should also be able to understand why investing in most actively managed (aka high expenses) funds makes no sense. The great majority of fund managers can’t outperform because they have no Edge over the other fund managers.
Investing is not like other areas of life. Being smart and hard-working is not enough to produce outperformance. Getting up early, going to business school, staring at Bloomberg News and scurrying to meetings with management teams does not give fund managers an Edge.
Career risk is the biggest risks faced by professional fund managers. Most fund managers can not outperform because they are not willing to do anything different enough to their peers and to their benchmark to risk their over-paid jobs. So investors in active funds tend to get an average market return (before fees) and underperformance after they’ve been clobbered by the impact of fees (think of this as a negative Edge).
The best way to gain an investing Edge is by controlling your emotions, acting rationally and being able to take a long-term view unconstrained by investment committees.
We individual investors can do something that is both rational and different from the herd. This means buying stuff that other people temporarily don’t want and / or is demonstrably cheap for some reason. We then have to have the patience to wait for the market to reflect the underlying value. This is simple but not easy.
You can try to do that via stockpicking but the easiest way to own a slice of the global capitalist system is via a low-cost global equities index tracker fund.
As for day trading, well, you can leave that to Frankie.
* ((19/37) x 0) + ((18/37) x 200) = 97.3
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