Chrib
Finally, some intelligent arguments! However, while you make some very interesting points, they do not undermine my argument. Why? Well, let us start with your first point about investing in a 401(k).
Point 1: Don't forget that one can roll over one's 401(k) into an IRA. Further, one can parlay IRA gains into additional funds that far exceed the limitations you mention
While it is true that with a 401(k) you can increase the maximum allowable tax-deferred contribution (I believe it is currently $15,500) this argument is flawed because an investor in a 401(k) CANNOT invest his money in the entire universe of securities. Rather, 401(k) plans are limited to certain types of investment options. For example, in the typical 401(k) plan the employer will offer the employee a list of investments options. These options usually include certain money market mutual funds, passive index mutual funds or active funds, international growth funds, long-term and short-term bond funds, and (in some very limited cases) small groups of individual common stocks. It is because of these investment option limitations that trader is really unable to implement the same types of strategies that he would otherwise implement outside of a 401(k). After all, I think most traders would agree that (a) it is nearly impossible to properly trade any type of mutual fund since purchases and sales can only be made at the end of the trading day (i.e. no intraday buying and selling) (b) that they would usually never trade a bond or money market fund (c) that it would be especially difficult to only trade the select group of common stocks (if any) offered by the employers’ plan. Therefore, since a 401(k) severely precludes a trader for purchasing and selling the type of securities necessary to successfully implement a profitable trading strategy we can reasonably conclude that a trader would have to implement such a strategy outside of a 401(k), thereby still limiting the trader to the $5,000 maximum allowable contribution under a Roth IRA and subjecting him the tax disadvantage on contributions in excess of this maximum allowable amount. Also, even if we were to suppose that an employer offered an employee a diverse set of individual common stocks through the employers 401(k) that program is still sponsored by the company, and therefore operated through the company's brokerage service (someone may need to double check this because I am not entirely positive about it, but I am pretty sure). I think it is reasonable to assume that these brokerage services are not companies like Zecco, but large institutional brokers such as Fidelity or Merrily Lynch. These brokers typically charge at least $10 per trader in brokerage commissions. Therefore, even if we assume that the employee offered a comprehensive list of individual common stocks, plan participants would still have to pay substantial commissions. For example, if it is $10 per trader (one of the buy side and one of the sell side) and the trader makes 2 trader per week he would incur over $2,080 in commissions. This would represent approximately 13.41% of the maximum allowable contribution. Thus, even if the trader were to avoid the tax burden in a 401(k) it would immediately be offset by the additional commission incurred by the trader, thereby causing him to still underperform the long-term investor. Finally, the ability to parlay gains in the Roth IRA does not affect my conclusion because so too would the long-term investor.
Point 2: The best traders, because they control their reactions to the market, in fact do make far more from the market even on a tax-adjusted basis than those who are passive
Do you actually have empirical research to support this or is it just your opinion because as I have demonstrated in my previous examples your claim seems very unlikely. For example, a passive investor in the 28% marginal income tax bracket who invests $1,000 per year and earns a pre-tax market return of 12% per annum for, say, 10 years would compound his total wealth to approximately $2,726.80 after-tax, or 10.55% per annum. In order for the trader to match this performance on an after-tax basis (assuming the same circumstances for both) his pre-tax market return would have to be 14.66%, or 2.66% greater than the long-term investor (and this is before bid/ask related costs). Therefore, if your claim is correct and they are outperforming the passive investor by, say, 2% after-tax (a return that would certainly be “far more”) they would have to earn a pre-tax market return of 17.43% per annum for 10 years pre-tax. That is they would have to outperform the market averages by 5.43% per annum for 10 years, which would classify them among some of the best investors in the world. Moreover, even if the best traders were somehow miraculously doing this it is unfair to compare them to a passive investor. Rather, we must compare them to the best long term investors such as Warren Buffet, Eddie Lampert, and, say Seth Klarman. They have earned 22%, 29%, and 20%, respectively, for 20 years+. This averages to approximately 23% per annum (I assuming this is after-tax). Thus, the good trader would have to earn a pre-tax market return of 31.94%. That is for the best trader to outperform the best long-term investor over a 10 year period would imply that he outperform Warren Buffet by 10% per annum. Moreover, as I have stated this excludes bid/ask related costs. Tack these on and you see how unreasonable this claim is (by the way if there is empirical research refuting my claim, please let me know because I would love to research what these great traders are doing). Also, just as an aside, in 2000 Brad M. Barber and Terrance Odean published a study in the Journal of Finance entitled “Trading Is Hazardous to Your Wealth.” In that study they examined the returns of 78,000 household investment accounts from January 1991 to December 1996. There conclusion was that traders are consistently underperforming the market. As stated in the conclusion of their article:
“Our most dramatic empirical evidence is provided by the 20 percent of households that trade most often. With average monthly turnover of in excess of 20 percent, these households turn their common stock portfolios over more than twice annually. The gross returns earned by these high-turnover households are unremarkable, and their net returns are anemic. The net returns lag a value-weighted market index by 46 basis points per month (or 5.5 percent annually). After a reasonable accounting for the fact that the average high-turnover household tilts its common stock investments toward small value stocks with high market risk, the underperformance averages 86 basis points per month (or 10.3 percent annually).”
Also, just because someone had a return of 56% on their portfolio in a given year is not strong evidence to support a trading strategy. For example, I currently have a 46% return on Meritage Homes, an Arizona based home-builder, and a 200% return on purchases made in the Radian Group, a mono-line mortgage insurance company, but this doesn’t mean that these returns are sustainable or that they provide meaningful indications of my long-term performance. Rather, they are simply portfolio aberrations. To evaluate what strategies are strong an analysis of consistent long-term performance is necessary, not windfall gains that occur over one or two years.
Point 3: Traders have the advantage of cash flow.
Absolutely! Traders certainly have a liquidity advantage. That is by the nature of trading they have gains and losses throughout the year, which can be used to pay for bills. This liquidity element can have utility for many individuals. However, in my example of the two M.B.A.’s who invest $10,000 per year for 40 years at 12% per annum pre-tax, that liquidity advantage would cost the trader well over $3,000,000 in terminal wealth. Personally, I do not value the additional cash flow that much. Perhaps you do.
Point 4: While you read the tax code as encouraging LTBH, I read it as equally encouraging voluminous amounts of short-term trading - if you qualify as a bona fide trader, you may deduct your expenses on Schedule C, items such as: margin fees, a computer, home office, a television (for CNBC), Internet, etc. All this and your primary income is not subject to Medicare, Social Security, FUTA, SDI, etc because it's Schedule D income. Investors are afforded no such perks.
Firstly, a long-term investor can deduct the same items on Schedule A as a miscellaneous deduction so long as the amounts exceed 2% of adjusted annual gross income. Therefore, while there is a tax disadvantage I suspect it to be minimal. More importantly, however, is that in order for you to even qualify for Schedule C deductions you’re most likely going to have to trade for at least 30 hours per week and make over 500 traders per year (technically this isn’t defined but cases in the tax court are usually rejecting individuals who claim they are bona fide traders who trade less than this). Obviously, this carries with it a substantial opportunity cost. For example, while you’re spending hours and hours a week trading the stock market so that you can classifying you miniscule margin interest and Wall Street Journal subscription as a Schedule C deduction the long-term investor could be earning, say, $15 dollars per hour and investing that money into a passive indexed mutual fund. At $15 dollars per hour for 30 hrs a week you’re looking at approximately $23,400 per year, or approximately $18,090.9 after personal income and FICA taxes (assuming the pre-2003 marginal income tax rate of 28%), which could then be reinvested into a passive index mutual fund. Therefore, if you could earn 12% per annum pre-tax for 10 years you are essentially foregoing over $293,036.71 in terminal wealth simply to take, say, a $500 deduction MAX per year. I not exactly sure what is so encouraging about this. Moreover, start adding the bid/ask spread related transaction cost to a 500 trades per and you are just asking to underperform.
Point 5: Furthermore, the tax argument is a red herring because one can simply submit the example of a long-term trader. My mom is such a trader. She holds all her positions for over a year.
This argument is also a red herring. Firstly, your mother is the exception to the rule. So attempting to generalize using her as an example misses the point. Secondly, and more importantly, she still incurs taxes each year, albeit it at the long-term capital gain rate (I noticed that you have correctly edited for this in your post). Nonetheless, it is this non-deferral component that is far more important than the differences in tax rates. For example, even if we assume that your mother qualifies for the 5-year capital gain rate of 18% (instead of the 20% she would pay realizing gains each year) because she fails to defer her taxes she would still underperform the buy-and-hold investor by a significant margin. In fact, if they both earn a pre-tax rate of return of 12% per annum (with all due respect she isn’t earning 25% per annum), invest $5,000 per year, and do this for, say, 40 years her terminal wealth would grow to $2,118,867.94 after-tax, while the long-term investor would see his wealth grow to $3,181,074.82 after-tax
Point 6: I take issue with your modeling of a 12% or 20% return. Returns have had such a high variance over time. Even you must agree that there are bull markets and bear markets. Do you? The returns from 2000-2003 look very different from those spanning 2003-2007. Traders may cherry-pick when they play, while LTBH must take bad with good. Heaven forfend should one require cashing out one's arduously accumulated LTBH holdings during a year such as 2003.
I completely agree that returns vary overtime, but it does not affect my decision to use a straight 12% or 20%. The reason is because they are simply average returns. In other words they already incorporate the fluctuations. That is if I would have modeled a 20% rally for 4 years and then a 15.12% decline for one (or what have you) that return would have exactly equaled a compound return of 12% per annum for five years. Thus, it doesn’t matter how I modeled it. Moreover, the purpose was simply to put the two strategies on a level of comparability to demonstrate the tax and transaction cost consequences. Secondly, while it is true that traders have the option to cherry-pick, an underlying assumption of that argument is that the technical analysis can time the market. Empirical research, however, has shown that that is very, very difficult to do, especially consistently. Moreover, while it would be unfortunate if a buy-and-hold investor had to sell during a major bear market, it is a risk faced by all market participants. The trader, for example, could just as easily get stuck in one as well. And given the difficulty of timing stops and bottoms would probably get equally burned. Secondly, given that the long-term investors investment horizon is usually very long a 20% decline in the market, say, 40 years down would probably be immaterial after it has already increased many hundreds, or even thousands of percent. For example, at a 12% average pre-tax return per annum for 40 years followed by a 20% market correct in the 41st year would only reduce the long-term investment compounded annual rate of return to 11.38%, not a very material difference. Moreover, he always has the option to wait. After all, most correction regain their lost ground in less than 2-3 years.
Point 7: I remember one of the key examples given in that book, held up as the pinnacle of a great, fundamental business - great profits year after year, a wonderful company that could be held until the grave. This was the first example held up by Mary Buffett as an ideal business to own. That business was Fannie Mae: http://bigcharts.marketwatch.com/
I think a presumption in your argument here is that once the long-term investor purchases an investment he simply forgets about it. This is obviously not true. Buy-and-hold investing should really be coined buy, hold, and monitor investing since you subject your investments to quarterly review. After all, if you think the fundamentals of the business change, or you’re unhappy with what the business is doing you can always sell. As a case in point Warren Buffet sold Fannie Mae in 2000 or 2001 because he realized they were talking unecessary risks (check the recent CNBC interview).
Point 8: I observe that markets correct 33-66% of any advance, and this is an observation that is true for any time frame, and for any market (stock) no matter how solid fundamentally. Why? Because the ultimate irreducible is the human element: prices are motivated by groups of humans making evaluations, from the millisecond level to the span of a generation.
Is it really true that a market correct by 33-66% after any advance in any time frame? This seems like a bold statement. In fact, I can think of some very easy questions to undermine this argument. For example, how long do you measure an advance? Is it after 10%, 20%, 30%, 40%, or 50%? Furthermore, how long do you define a time frame? Is it a daily chart, a weekly chart, a monthly chart, a yearly chart? I think you can see how this becomes a slippery slope. What’s even more problematic is that is it comes eerily close to data-mining. For example, anyone can look back at a historical chart and identify a major decline after a major advance. However, what is at issue is not the fact that such advances and declines exist, but whether or not you can accurately and consistently identify when an decline is over and when an advance will begin (and vice versa). After all, no one disagrees that markets exhibit these characteristics and that human behavior is one the primary causes of it. The question is can you accurately predict it. Empirical research would suggest that you cannot.
Point 9: The fundamental flaw in fundamental analysis is the amount of emphasis placed on a merely ancillary entity: the good being evaluated. In fact the good in question is irrelevant - it could be securities, houses, tulips; it is the market participants' actions that are invariant from market to market
The good is certainly not irrelevant. Why? Because the good in question always bears an impact on value, otherwise arbitrageurs could exploit inefficiency. For example, suppose ABC Company operates in the casket manufacturing business, a very stable and recurring business (after all people don’t stop dying). Moreover, ABC Company controls over 50% of the market and competition is not an imposition. Currently, let us suppose the business generates $100 million in stable net after-tax cash flow. This cash flow is expected to remain constant into perpetuity. Also, because the business is about as risky as the market, rational economic agents require an after-tax rate of return of 10% per annum. Under these conditions the business should be priced at $1 billion. Suppose, however, a new cryogenically frozen process by XYZ Inc. has been announced for possible product development and because market participants “matter” they sell ABC Inc. short on concerns surrounding product viability. The stock tanks 50% to $500 million, or $5/share. However, ABC’s underlying cash flow has not changed! In fact, coming Q1 ABC Company generates $25 million in after-tax cash flow (consistent with its historical and future cash generating abilities). Even though the stock is now trading in the market for $500 million, has the value of the business changed? The answer is no! Why? Because even though it is “trading” in the publicly traded market for $500 million the business is still generating $100 million in after tax cash flow. Therefore, an institutional arbitrageur could simply come into the market take the company private, and at the current trading price of $500 million earn an internal rate of return of 20% rate into perpetuity. Of course, management working in the best interest of the shareholders wouldn’t actually sell the company for this amount. But, the arbitrageur (typically an institutional buyer) would simply begin accumulating shares at these attractive (and inefficient) yields until the value of the business increased to its correct value of $100 million. Thus, while the human element matters (i.e. the selling short caused the price to fall) the fundamental element matters equally so (the institutional buyer bidding the price back up to competitive yields). In fact, there is a book entitled Valuation: Measuring & Managing the Value of Companies by a group from McKinsey & Co (a very prestigious consultancy). In that book they actually demonstrate how remarkably close values track their fundamental worth overtime. Buy the book if you want to see what I’m talking about. Nonetheless, the point is that you are absolutely right: the human element does matter (think the 50% drop). However, values can never stray to afar from their intrinsic worth. Otherwise, arbitrageurs will step in. After all, not everyone invests with as much emotion as others.
So,
Which method sounds more logical to you?
I think you know my answer.
Angell