Trading: how valuable is it to do?

For professionals, very…

The short answer:  my experience is that competent professional trading supporting an equity portfolio manager can add one percentage point to annual returns.  Conversely, poor trading can subtract about the same amount.  Good trading, then, can take a third-quartile manager and put him in the second quartile; bad trading can do the opposite.

…for us, not so much

What about for you and me, though?

I think the key question for any individual investor is how much time is he willing to devote to investing.  A typical professional spends fifty hard–that is, not counting chatting in the coffee room with colleagues–at-the-desk working hours a week on his craft.  Even so, that’s not enough to keep pace with professional competition.  So the job of investing is usually split into three parts, one of which each professional in a firm will concentrate on.  The three are:  research, trading and portfolio management.

Realistically, we’re not going to work as hard as that, no matter what we tell ourselves.  So it’s essential for us to simplify and prioritize our activity so that we can do one or two things well, rather than do a half-baked job on several.

Committing our time to investing

As far as time commitment goes, I think the three parts break out as follows:

1.  portfolio management. Learning how to formulate a strategy takes the most time initially.  Once you actually create one, you’re thinking of it in odd moments most of the time, but your real work of testing, evaluating, trying to figure out what will come up next, is only done for short periods once or twice a month.  In terms of everyday effort, this most important part of managing your money takes the least time.

2.  securities analysis. Selecting the individual stocks, if any, for your portfolio requires a considerable initial effort to learn about he companies, their histories and their prospects.  Monitoring company developments and the stock’s price action takes daily attention if you want to do things right.

3.  trading. Trading can absorb your entire day, if you want it to.  After all, investment managers pay their traders hundreds of thousands of dollars yearly to do just that–to watch the markets, from overseas and pre-market activity to after-hours trading.    The question for us is whether, if we’re going to devote, say, 15 hours a week to our investments, becoming expert in this area is the most valuable use of our time.

(I probably should mention that I do have a  trading experience.  For about five years I ran a global fund where I was the manager and also did all the trading.  I won’t claim to be a really proficient trader, but I’m not that bad.)

Trading takes up a lot of time

An example:  one of my sons, a twenty-something, asked me recently to sell the (small amount of) PALM that he owned and put the proceeds into ATVI.  He had bought PALM, which I consider a really speculative stock (too much so for me), after a Bono-related investment vehicle had given the company an infusion of cash that would allow it to complete and launch the Pre. My son later became convinced that the Pre was going to be upstaged by the raft of Android phones now being released–which is why he wanted to sell.

Anyway, my son gave me a limit of $12 for PALM and none for ATVI.  I placed two limit orders online, one for PALM at $12 and another for ATVI about 2% below the previous close.  I thought the market was going sideways and both stocks were volatile enough intraday that the limits would likely hit.  I then did other things.

On day one, nothing happened.  On day two, prior to the open an analyst released a buy recommendation on PALM that pushed the stock up to $12.27 in early trade.  The stock faded as the day went on and closed at about $11.65.  Of course, I had sold at $12.  on day three, ATVI fell about $.05 below my limit intraday, before closing slightly above it.

Could I have done better?  Yes.  Speaking strictly about trading PALM, I could have spent all of day one and the first couple of hours of day two watching the market.  When I saw the new buy report on day two, I hopefully would have let the stock run and sold at, maybe, $12.20.

For us, it’s too much

But that would have meant spending eight or nine hours monitoring trading in PALM to get another 2%.  As one of my first bosses told me when I was talking about making a trade that might get me 10%–our job is to look for the 30%s and the 50%;  105 is too little to waste time and energy on.

To that, I’d add that if we’re going to allocate ten hours a week to investing, it’s better to spend that time trying to find the next AAPL rather than blowing a week’s worth of time looking for a 2% that may or may not be there for the taking.

Why do all the discount broker ads talk about trading, then?

Three reasons:

1.  The obvious one.  Trading is the service a discount broker offers.  The more you trade, the more money the broker makes from your account.  (See my posts on how your broker gets paid.)  The broker will also benefit if your account grows, but he will gain more from high turnover in an underperforming portfolio than from a low turnover one that outperforms.

2.  Trading tools are easy to provide.  You can even get them for free from Yahoo or Google.

3.  Offering trading advice is much simpler than offering investment advice.  Giving investment advice to a broad range of customers isn’t cheap or easy.  The broker opens himself to the risk of litigation if the investment advice proves unsound or if it is unsuitable for the economic circumstances of a given client.  So the discount broker has to have a research staff (which will end up costing the firm a lot of money) and representatives who will do risk tolerance and other suitability analysis.  Suddenly, the firm that does this not a discount broker any more.  It’s an old-fashioned “full service” broker.

Besides, discount brokers already offer back office services to independent financial planners.  So they would be competing against their own customers.

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