I set out to explain why successful traders are so secretive, by stepping through a logical argument of how a trader, if he publicizes his trading decisions, will almost certainly sooner rather than later undermine his own success. For many reading this, secrecy among successful traders may be a truism not requiring elaboration. However, for anyone wishing to hear the story, here it is:

Let’s call our (hypothetical) young trader Mr. Bright. Assume that Mr. Bright either has an innate and remarkable ability to discern patterns in stock price movement or, alternatively, has developed a sophisticated computer program that can correctly forecast price action. Using his uncanny ability or his financial technology, Mr. Bright buys and sells stocks, typically taking positions for only a few hours, and achieves a highly favorable track record, soon vaulting him to multi-millionaire status.

One sunny morning, driven by apparent altruism camouflaging a layer of megalomania, Mr. Bright wakes up and decides to “share the wealth” with others by publishing his trading decisions via a website, announcing his buy and sell targets for particular stocks, and detailing his actual trades real-time.

Now, the media, always looking for a good story, is quick to pick up on young Mr. Bright’s impressive track record and his openness and willingness to educate anyone who will listen. However, the public, including numerous “little guy” investors, who have only painful memories of losing too much money on rumors, hearsay and not-so-sound “advice” from “experts,” is more skeptical. At first, only a few people take Mr. Bright and his predictions seriously enough to put their own hard-earned money at risk mimicking his trades. However, the success of the bold early adopters soon attracts a small army of followers, who are eager to partake of the “easy money,” free for the taking simply by copying Mr. Bright’s trading actions–buying when he buys and selling when he sells.

For quite a few months all is well. Mr. Bright’s trades, along with those of his army of copycats, are profitable more often than not. He and his followers are on track to realize a 100% return during the first year. To the surprise of all skeptics, Mr. Bright is consistently putting money into the pockets of every little investor in his army and quickly becoming a popular hero.

By this time, as success tends to generate its own publicity, Mr. Bright and his uncanny forecasting system have caught the attention of professional investors (hedge funds, proprietary trading desks at investment banks and others). Since Mr. Bright makes a habit of publishing his trades real-time, he and his army of followers are an easy target for deeper-pocketed pros.

The strategizing in the pros’ minds goes like this: Seeing that the stocks that Mr. Bright and his army buy rise so predictably, why not kick in a few dollars and join them on the way up? Then, instead of waiting for Mr. Bright’s typical 10% rise before taking profits, how about front-running Mr. Bright and his army by selling out a little sooner, say at 9% profit, and proceeding to go short in significant size? As the stock starts to fall due to our short, Mr. Bright and his army will have little choice but to cut their profits and join us in selling, thereby pushing the stock down further and faster. As Mr. Bright and his army go into rapid retreat, the corresponding surge in trading volume and collapsing stock price will provide us pros with an opportunity to buy back shares to cover our short for a quick profit. As is easy to see, Mr. Bright and his army, with their well-publicized trades, will inevitably fall right into our trap!

In essence, Mr. Bright’s system breaks down when more money is put into play. While the system initially succeeds in predicting price movement and generating profits for Mr. Bright and a small army of followers, the forecasting ability of the system vanishes when deeper-pocketed pros toss more money into the game. The very actions of Mr. Bright and his followers become a significant part of the overall market and, ultimately, the predictability of their behavior becomes a target of the pros.

Ironically, Mr. Bright’s uncanny forecasting ability, when publicized to allow everyone free access to his trading decisions, itself becomes a predictable aspect of the market. In other words, the very act of revealing the predictions of a successful trading system predictably undermines its own ability to predict!

Moral of the story: Mr. Bright wasn’t so bright after all.

Corollary: The brightest traders keep their systems secret.

Reader’s Question: Next year we will sell our family farm and expect to net in excess of $200,000. Our tax preparer says to pay the tax and invest the rest. Is this correct? If so, where should we invest? My husband and I are both in our 60s and would certainly like more income to help us enjoy this stage of our life.

Since you are selling real estate, you should first determine whether or not your farm qualifies as your principal residence; in accordance with IRS rules, if your farm property is your home, you and your husband might qualify for exclusion of up to $500,000 in profits from your capital gains tax calculation. Here’s a Bankrate.com article covering this home-sale tax exemption.

If your farm is not your principal residence, then it will likely be treated as an investment property and you can qualify for a “like-kind” 1031 tax-deferred exchange if you meet the IRS requirements. Again, here’s a Bankrate.com article for an overview. You might consider swapping your farm for any of a variety of common types of rental income property (e.g., apartments, small offices, self-storage facilities). Appropriately selected rental properties are capable of offering solid positive cash flow, which can provide the income stream you are seeking. With real estate markets weakening across the country, now seems to be a good time to start looking for properties being offered at attractive prices by motivated sellers.

As your tax preparer suggests, you can alternatively just pay any capital gains tax you might owe upon sale of your farm and roll the after-tax proceeds into other investments of your choice. If you choose to follow this option, I would suggest paying close attention to fees and expenses when reinvesting. Minimizing investment management fees will tend over time to give you higher returns. If you are comfortable choosing individual stocks (including ETFs and REITs, many of which pay substantial dividends) and bonds on your own, you’ll save by avoiding having to pay fees to a fund manager. Opening an account at a reputable discount broker can also help reduce transaction costs. If you decide that mutual funds suit your investment style better than buying individual securities directly, I suggest seriously considering only funds with low fees and low portfolio turnover.

In case you have not yet seen it, you might also wish to peruse my earlier comments on wealth generation in a five-part series on long-term investing.

Reader’s Question: Do you think the U.S. stock market will provide at least 10% to 20% returns over the next one to two years? Also, how about foreign equity markets?

I am bullish on equities over the long term and think it very possible that the U.S. stock market will see returns around the level you indicate. Negative factors–softness in residential real estate, sub-prime debt problems, possibility of recession, record high oil prices, weakening dollar–have potential to derail the current bull market and will continue to worry investors. Nevertheless, despite the short-term negatives, equity markets tend to exhibit a secular rise on the back of economic growth–and this long-term trend, with solid footing in our world’s market economy and capitalism, is unlikely to subside anytime soon.

Think Global

Rather than focussing solely on U.S. equities, I would encourage you to think and invest globally, if you aren’t already doing so. The pie chart below shows how the U.S. accounts for about 27% of the world’s economy as measured by nominal GDP. This means that almost three-quarters of the world’s economic output (i.e., the overwhelming majority of the pie) is generated outside of the U.S. Certainly, the U.S. remains the world’s largest economy by a wide margin; however, rapid economic growth rates elsewhere provide a reason to look beyond U.S. borders.

Economic Growth Matters

The world’s three largest economies–U.S., Japan and Germany–all have real GDP growth rates in the neighborhood of 2% to 3% annually. That’s very sluggish when compared to high growth rates in many other countries among the world’s largest 15 economies. Most notably, China continues to show robust 10% to 11% growth, India around 9% or 10%, Russia around 7%, and South Korea and Mexico about 4% to 5% growth. Since GDP growth in the underlying economy drives corporate revenue and earnings growth, which in turn determines stock price performance, it behooves us to focus in on high-growth countries.

As investors, we want growth, but we also want to make sure that we are not paying too much for the growth we get. A good way to gauge the cheapness or richness of entire stock markets is to look at the P/E ratios of representative ETFs. Barclays iShares manages country-specific ETFs that can serve as proxies for most of the largest economies. For example, one of their most popular ETFs is the FTSE/Xinhua China 25 Index (NYSE: FXI), which invests in H-shares of 25 large companies listed in Hong Kong and doing business in China. This China ETF has a market capitalizaion-weighted P/E ratio of 31, as of the end of September.

It is helpful to plot P/E ratio against GDP growth to develop an intuitive feel for how cheap or expensive the various stock markets are. In the graph below, I have drawn lines sloping upward from the origin for the four countries with the most attractive (i.e., lowest) ratios of P/E (for proxy ETFs) to GDP growth rate (for the corresponding countries). This composite ratio is a type of “PEG ratio” that measures P/E relative to growth, allowing for a quick comparison of low-P/E, low-growth and high-P/E, high-growth investment alternatives.

Observe how the ETFs of India (NYSE: INP) and China (NYSE: FXI) offer the most attractive PEG ratios, indicating that even though their respective stock markets are currently trading at relatively high P/Es of 23 (estimated) and 31, respectively, the double-digit (or near-double-digit) growth of their underlying economies appears to support their high-P/E valuations. The ETFs of Mexico (NYSE: EWW) and South Korea (NYSE: EWY) also show attractive PEG ratios.

Prospects for Growth and Profit

Although it is extremely difficult to predict which stock markets will rise the most over the next year or two, or whether the recent strength of global equity markets (particularly China and India) will continue in the near-term, I offer two suggestions:

1. Invest Globally: As a baseline when investing in equities, weight countries in approximate proportion to their contribution to world GDP. ETFs provide a means for taking on exposure to foreign equities while keeping costs and management fees low. Buying ADRs (U.S.-listed shares of foreign companies) is another way to go for those who enjoy (as I do) investing in individual companies. While U.S. equities may comprise the largest single-country contribution, all of the non-U.S. countries together should, in my opinion, add up to more than half of your overall portfolio.

2. Over-weight High-Growth Countries: Given their high GDP growth, China, India, Russia, South Korea and Mexico are good places to search for equity investments. Investors willing to take a long-term view and ride out the higher volatility of these markets stand to benefit from the tailwind that higher GDP growth provides.

Reporting this week of Mukesh Ambani and Carlos Slim’s rapid ascent to the #1 and #2 positions in world wealth ranking (both appear to have edged out Bill Gates) is a sign of India and Mexico’s strong economic growth and soaring stock market fortunes (as well as evidence of how concentrated wealth is among the super-rich in these countries of relatively low per-capita GDP). Also, Warren Buffett’s investment in POSCO (NYSE: PKX) and other South Korean stocks is indicative of the potential upside this Asian market offers.

(Disclosure: The author does not currently have positions in any of the ETFs or stocks mentioned in this article but is overweight in non-U.S. equities from high-growth countries.)

Reader’s Question: I’m 28 years old. My wife and I both work as electrical engineers in jobs that pay well. Using our savings we have been buying income-producing real estate to replace our employment income and now own 11 units. Is real estate the best vehicle for achieving our goal of becoming financially independent to free up time for activities we consider more meaningful? I have not found other investments that offer such handsome cash yields and permit a similar degree of leverage. Also, regarding leverage, what is the optimal amount of overall leverage for our property portfolio? Is it wise to “lever to the max” with exotic strategies (like wrap notes on properties purchased subject-to), or would we be better off de-leveraging our portfolio so that we don’t need to keep as much cash on hand to cover downside risk associated with leverage? I am struggling with the correct amount of property to purchase given our cash reserves.

In asset allocation and capital structure, the two areas of portfolio management your questions relate to, there are many different investing approaches, each of which has its own merits and unwavering supporters. Rather than try to show in any objective sense that one approach is always superior to the others, I will provide a personal perspective based on my own investing experiences, going broader than your specific inquiry to provide a fuller picture of what has worked for me over the past 25 years. I hope anyone reading this article is able to benefit from what I have to say; however, since even small differences in personal circumstances and preferences can sometimes lead to very different choices and approaches to investing, I encourage you to consider my opinions only as a point of reference, while proceeding to seek out advice from professionals who have the time and expertise to understand your situation thoroughly and work with you more closely to achieve your goals.

Real Estate Investing During the 1980s and 1990s

Since you are targeting a high cash yield and refer to your real estate as “units,” I assume that you own apartments (though office buildings, neighborhood retail stores, mixed-use properties, storage facilities, mobile home parks and other real property are also all capable of generating predictable cash flow).

During the early 1980s, I made my first income property investment using a few thousand dollars I had managed to save from my job as a teaching and research assistant while studying for my graduate degree at an East Coast university and living frugally in a shared student house. I invested in apartments in California through a partnership run by an experienced general manager familiar to me through friends and relatives. We were leveraged at about 70% loan-to-value and the property produced good cash flow distributions. With California real estate steadily appreciating, the investment did well throughout the 1980s.

Following graduation in 1985, I took a high-paying job on Wall Street and continued to invest my (now more substantial) savings into other apartment buildings in Southern California. With occupancy above 95%, rents rising at above 5% per year, and limited available land for new development, rental properties continued to appreciate. I recall at the end of 1990 receiving an unsolicited offer for a 16-unit property of ours at a price of $1.15 million (or $72,000 per unit, a very attractive price at that time), which on paper produced a total return-on-equity of 150% in less than three years!

But good times, of course, don’t last forever. The U.S. recession beginning in late 1990 hit Southern California hard. Real estate prices softened and buyers evaporated. Realtors and investors caught in the fallout coined the phrase “Stay alive till ’95,” expressing their confidence that the market would recover by the middle of the decade. Recovery, however, was slower than expected, and significant market strength did not return until around 2000, a full decade following the 1990 peak.

During the market nadir in the mid-1990s, the vacancy rate in one of our buildings rose to 15% and we had to reduce rents by about 10% and offer move-in specials to attract new tenants. In the worst year of operations, cash flow became negative by about 1% of property value (which would have been worse if we had been leveraged more highly).

After what in retrospect was a long roller-coaster ride, partially buffered by not being over-leveraged, we ended up selling the properties, mostly during the market runup from 2000 to 2005. During my total 10- to 15-year holding period, I achieved acceptable but unimpressive, single-digit compounded annnualized returns. This muted, bond-like, long-run performance of an equity investment is largely a reflection of the extended market slump during the mid-1990s, but perhaps the more important outcome from this experience is that we survived and even managed to make a little money during a period when a number of more highly leveraged investors and developers faced foreclosure and bankruptcy.

Lessons from the Last Time Around

With attention to leverage and cash flow, a few observations may be helpful:

Cyclicality: Despite a strong secular tendency to rise indefinitely, real estate markets also exhibit significant cyclical behavior. On a timing clock, with 12 o’clock at the market’s top and 6 o’clock at the bottom, I would pair up the following times and dates:

9 o’clock: Market rises in late 1980s
12 o’clock: Market peaks at end of 1990
3 o’clock: Market falls during early 1990s
6 o’clock: Market bottoms around 1995
9 o’clock: Market recovers in late 1990s

Though it may still be too early to judge conclusively, I suspect that we will likely look back at 2005 or 2006 as defining another 12 o’clock real estate market peak.

Leverage and Cash Flow: Leverage slices both ways, producing quick double-digit returns on the way up (as during the middle and late 1980s) and often even quicker negative double-digit returns on the way down (as from 1990 to 1995). As a general principle, I believe it prudent never to leverage a property beyond the zero-cash-flow breakeven point between positive and negative operating cash flow (after debt service and a reserve charge for major repairs, but before depreciation and amortization). A conservative rule of thumb for determining appropriate leverage is to apply a stress test by bumping the economic vacancy rate up to two or three times its normal level (e.g., 5% vacancy becomes 10% to 15% vacancy) and making sure that the property still has either sufficient positive cash flow or adequate cash in the bank to cover this worst-case scenario for a full year of stressed operation.

Total Investment Return: While prudent cash flow management and avoidance of over-leverage (of which a wrap note can be a tell-tale sign) are important for survival during times of protracted rental market weakness, investment returns are often more impacted by property price appreciation than cash flow. Particularly for investment horizons of 10 years or shorter, market timing tends to matter. Admittedly, buy and sell decisions are difficult to get exactly right and each time around is different from the previous times, but I believe that it is possible to cultivate a type of “wisdom” about the markets by observing the macro and local economic forces and their influence on prices over many cycles, thereby developing a slight edge over less diligent players.

Don’t Forget About Alternative Markets

Between 2000 and 2005, while I was selling my units in California, I seriously looked for replacement properties in the Washington state area where I now live. My target was a 15% return-on-equity over a pro forma five-year investment horizon, consistent with an 8% cap rate, at 70% loan-to-value, 7% debt service (principal and interest), a 10% cash-on-cash return, and 3% annual property price appreciation, fully accounting for property management fees during the holding period and brokerage fees upon sale. During my property search, I made a handful of offers but was unable to close on a desirable investment property at my price target.

What drove my direct investment target was an investment alternative: indirectly investing in real estate by buying shares of publicly listed REITs. At that time, which was in the wake of the dot-com bubble when office vacancy rates had risen to 20% in high-tech centers, shares of office REITs were trading at depressed price levels consistent with my 8% cap rate and 10% cash-on-cash return target. I viewed office REITs as more attractively priced and having more upside pootential than apartment, retail and other REITs, and proceeded to roll my sales proceeds from the California apartments into shares of Equity Office Properties and Trizec. As good fortune would have it, these two office REITs ended up getting bought out at premium prices in late 2006 and early 2007 by large private-equity buyout funds, providing me with returns that well exceeded my original total return target.

The message here is that, before concluding that direct ownership of income-producing real estate is the best way to meet your investment objectives, I would encourage you to give serious consideration to at least the REIT market and, more generally, the overall stock market. Since the middle of last year, with the subprime crisis feeding recession fears, REITs have taken a fall and are again beginning to look relatively attractive. In my opinion, HRPT Properties (NYSE: HRP), an office REIT with class A and class B properties in both major and more minor cities, is worth considering, since it is now trading at just 65% of book value (equivalent to a “see through” 9% to 10% cap rate with a 14% to 15% cash-on-cash return) and offers an 11% dividend which looks stable. This or other REITs or other dividend-paying stocks may also provide you with the sense of financial independence you are seeking through direct ownership of real estate.

Although I currently own no real estate other than my own residence, I expect again to buy investment properties when an attractive opportunity presents itself. My guess is that the U.S. real estate market as a whole is now at about 3 o’clock on the timing model mentioned above, and could have another year or two to go before reaching the 6 o’clock bottom. The Seattle market where I am is still performing stronger than most other markets, which leads me to believe that I could have even a longer wait if I keep my local focus. On the other hand, I’m sure that there must be a few markets in other states (including your area?) where great deals may be found even this year.

When a Job Can Be More Than Just a Job

Your desire to generate investment income to give you financial freedom to pursue other activities you believe will be more fulfilling than continuing to work at your job as an engineer is a common goal of many people in our 21st-century society dominated by large corporations driven by efficiency and profit objectives. For better or worse, within a few years on the job, most of us Americans come to view our occupations primarily in financial terms, i.e., exchange of our labor for money, while disregarding less tangible benefits such as constructive participation in an endeavor for the good of society, contributing to the smooth operation of our economy, making widgets that we all need and use, helping others by applying our individual talents, etc.

Given the focus of so many Americans on becoming financially independent and retiring early, I was surprised recently to run across an interesting statistic indicating the extent to which America has become less aristocratic over the past century. In 1929, 70% of the income of the top 0.01% (or 1 out of 10,000) earners came from investment income derived from ownership of income-producing assets such as real estate, stock and bonds. By contrast, in 1998, again among the top 0.01% of earners, just 20% of income came from income-producing assets, while the remaining 80% came from wages and entrepreneurial income. (From Piketty and Saez, “Income Inequality in the United States, 1913-1998,” as cited in Rajan and Zingales, Saving Capitalism from the Capitalists, 2003, p. 92)

I find it intriguing and even inspiring that the bulk of the income of top earners comes from business endeavors that these top earners are actively involved in as wage earners and entrepreneurs. What this indicates is that today in America, even moreso than a few generations ago, tremendous opportunities exist for anyone clever enough, bright enough and enterprising enough to apply their talents constructively to provide products and services in high demand. In other words, we should view our labor not just as a simple exchange of our time for money but also, at a higher level, as a contribution to the advancement and betterment of society with potential for phenomenally high compensation for the highest achievers. I’m not sure how you are planning to spend your time if or when you do one day leave your current job, but here’s a suggestion: how about aspiring to rise to the level of those one-in-ten-thousand hardworking wage earners and entrepreneurs who are making a difference in our world? Generous financial and personal rewards are apparently available for those who succeed.

Certainly, investing to achieve self-sustaining personal lifetime income is a worthy goal to have. But, let’s not stop there. Anyone focussed and fortunate enough to get that far should, I feel, both for one’s personal satisfaction and for the good of society, actively proceed to find ways to share one’s expertise and continue contributing to improving the lives of everyone.

Reader’s Question: How does a buy-and-hold strategy compare to a trading strategy for ETFs [and stocks in general]?

Your question pertains specifically to exchange-traded funds (ETFs); however, because the buy-and-hold versus trade decision is basically the same for individual stocks, I will answer within the general context of equity-style investing.

Investing vs. Trading

The primary difference between a buy-and-hold approach to investing and a trading strategy is one’s time horizon. To some extent, the distinction is relative: a day-trader considers any holding period longer than a day or two to be investing, whereas a buy-and-hold investor might consider any portfolio with turnover exceeding just 10% or 20% per annum to be trading. For concreteness, however, let’s define “investing” as holding any position for a year or longer, in line with the cut-off for tax purposes between long-term and short-term capital gains. Within this definition, managers running portfolios with turnover exceeding 100% per year will be deemed to be “trading.”

Rationally speaking, the decision to invest or trade should be based on your assessment of two quantities:

“Pick-Up” in Expected Return: How much pick-up in return do you expect to gain by trading, i.e., by switching from one asset to another, such as selling one stock to buy another?
“Frictional” Costs of Trading: What are the frictional costs including broker’s commissions, bid-offer spread, tax impact of trading, and additional administrative time required to keep your records in order and account for trades?

Whenever expected pick-up exceeds frictional costs, it makes sense to trade out of one asset and into another that promises the higher return.

If markets are efficient, with perfect and instantaneous information flow among all participants, no pick-up in expected return should be available from switching out of one asset and into another; instead, frictional costs will only drag down returns. On the other hand, if it is possible to use available information to one’s advantage to outsmart others, then trading can be a highly profitable business.

Prominent Winners and Losers

A glance at popular lists of the rich and famous shows that at least a few people have been amazingly successful trading the markets. Here are some well-known traders on the Forbes list of the 400 wealthiest Americans:

George Soros (age 77): #33 on list, $8.8 billion net worth. Bachelor’s, London School of Economics. Founded Quantum Fund with Jim Rogers. With Stanley Druckenmiller, “broke” British pound in 1992, made $1 billion profit. Lost hundreds of millions with ill-timed investments in former Soviet Union 1996.
Steven Cohen (51): #47, $6.8 billion. Bachelor’s, Wharton, U. Penn. Founded hedge fund SAC Capital 1992 with $25 million in assets. Today manages $14 billion. Charges 3% of assets, 35% of profits; has returned an average of 34% net of fees each year since 1992.
James Simons (69): #57, $5.5 billion. Math Ph.D., UC Berkeley. Founded Renaissance Technologies 1982. Quantitative hedge fund uses complex computer models to analyze and trade securities. Fees as high as 5% of assets, 44% of profits. A $2.5 million investment in his funds in 1990 would be worth $1 billion today (for a 42% annualized return). Hires Ph.D.s over M.B.A.s. $25 billion institutional fund RIEF so far performing below expectations.
Stanley Druckenmiller (54): #91, $3.5 billion. Bachelor’s, Bowdoin College. Orchestrated billion-dollar raid on the British pound in 1992 with timely short position. Believed to help generate string of 30% returns for Soros’ Quantum Fund. Duquesne Capital Management, runs No Margin Fund.
Bruce Kovner (62): #91, $3.5 billion. Bachelor’s, Harvard. Started trading soybeans; turned $3,000 he borrowed on his credit card into $45,000. Forgot to hedge, lost half the profits. Founded Caxton Associates 1983. Caxton Global Investments hedge fund has returned 25% annually net of fees. Assets: $15 billion.
Paul Tudor Jones II (53): #105, $3.3 billion. Economics, Bachelor’s, Univ. of Virginia. Early success trading cotton on Wall Street. Founded Tudor Investment Corp. hedge fund 1980. Predicted 1987 stock market crash, returned 125% net of fees that year. Assets now $20 billion. Estimated average annual returns 24%; down this year amid summer’s violent market turmoil.
Kenneth Griffin (38): #117, $3.0 billion. Bachelor’s, Harvard. Started investing as undergrad, managing $1 million of family’s, friend’s money by senior year. Founded Citadel Investment Group 1990 with Frank Meyer’s money. His hedge funds said to have averaged 20% net of fees annually. Assets under management exceed $16 billion.
David Shaw (56): #165, $2.5 billion. Ph.D., Stanford. Investment geek uses complex algorithms to capitalize on tiny anomalies in the stock market. Former professor of computer science at Columbia U. Launched hedge fund D.E. Shaw & Co. Assets have swelled from $28 million to $34 billion in 20 years (or 43% annual compounded asset accumulation).
David Tepper (49): #239, $2.0 billion. M.B.A., Carnegie Mellon. Ran junk bond desk at Goldman Sachs. Started hedge fund Appaloosa Management in 1992. Fund up 150% in 2003; believed to have averaged 30% returns net of fees since inception. Manages $7 billion.
Louis Bacon (51): #286, $1.7 billion. Literature, Bachelor’s, Middlebury College. Founded Moore Capital in 1989; returned 86% in first year on savvy bet that Gulf war would drive up oil prices. Assets under management: $13 billion. Last year returned 16.7% after fees (25% of profits, 3% of assets).
Daniel Och (46): #317, $1.5 billion. Bachelor’s, Wharton, Univ. of Penn. Took job in arbitrage at Goldman Sachs 1982; worked with Eddie Lampert , billionaire Richard Perry. Left to found Och-Ziff hedge fund with $100 million initial investment from Ziff brothers. Consistent returns: 16.5% a year after fees. Manages $29.1 billion.
Israel Englander (59): #317, $1.5 billion. Bachelor’s, NYU. Founded investment outfit Jamie Securities 1980s; firm collapsed. Created Millennium Partners 1990; fund said to have returned 17% net of fees. Assets under management $11.5 billion. Employees created 100 legal shell companies in order to market time mutual funds.

The persistent 15% t0 40% or higher annual returns these traders show is evidence that it is possible to realize consistent profits trading the market.

Lest we become too carried away with these success stories, we should also keep in mind that there have been many equally prominent “blow-ups” of risk-taking traders, including: Victor Niederhoffer, one of Soros’s former colleagues, whose funds failed twice, in 1997 and again this year; John Meriwether’s Long-Term Capital Management, the multi-billion dollar hedge fund run by ex-Salmon traders and even a couple of economics Nobel prize winners, which collapsed in 1997; and Amaranth Advisors, which spectacularly lost $6 billion in one week on natural gas futures in September 2006. This year’s subprime crisis is another example of how businesses, investments and trading strategies that have been profitable for many years can suddenly turn sour. Then, too, think about all the unlucky traders who lose money so quickly that we never get a chance even to hear about them!

Base Strategy: Buy-and-Hold

The only certain way to know whether you yourself have the ability become a successful trader is to commit both significant time and capital to trying. Unfortunately, most people have neither the time nor capital to spend finding out. Also, for those who seriously begin trading but fail, the costs can be very high, both financailly and emotionally.

In my opinion, instead of launching off and haphazardly trying your luck at trading, it makes sense at least initially to pursue a buy-and-hold strategy to exploit certain advantages it offers:

1. Long-Term Returns Favor Equities: The nature of capitalism as we know it in the U.S. and in most parts of the world is that laws and regulations are skewed to promote economic growth, corporate profits, and wealth generation for stockholders. In this environment, risk-taking buy-and-hold equity holders more often than not end up with higher returns than bondholders and cash-rich non-risk-takers. Therefore, it makes sense to allocate as much of your portfolio as you can to equities, reserving for cash and bonds only what you need for emergency living expenses (e.g., six months’ income in case you lose your job) or predictable future expenses (e.g., a college fund for children). While it is very difficult to predict whether equities will outperform bonds and cash in any given year, over periods of 10 or 20 years or longer, equities have generally outperformed.

2. Cost Efficiency: Compared to trading, buy-and-hold investing controls costs by keeping broker’s commissions and other frictional costs to a minimum. Though not as evident as a trading commission, the bid-offer spread is a cost that can often be larger than commissions. To give an extreme example, a micro-cap “penny” stock with a $0.06-$0.08 bid-offer (you can buy at $0.08 and sell at $0.06 in an unchanged market) actually has round-trip execution costs of an enormous 25% of one’s initial investment! At the other end of the spectrum are exchange-traded funds, the most liquid of which is the S&P Depositary Receipts (AMEX: SPY) with round-trip bid-offer costs of just 0.007% (or less than 1 b.p.). More typically, moderately liquid mid-cap individual stocks have bid-offer spreads of about 0.50% (50 b.p.).

3. Tax Efficiency: Keeping portfolio turnover to a minimum through buy-and-hold investing is also more efficient from a tax point of view. First of all, the long-term capital gains tax rate of 15% that applies to positions held for more than a year is substantially lower than the ordinary income tax rate running as high as 28% that applies to short-term capital gains on positions held for a year or less. For certain types of trading accounts, the IRS offers a favorable 60%/40% split between long-term and short-term capital gains tax treatment, which produces an effective tax rate of 20.2% (of course, higher than the 15% pure long-term gains rate). Also, since taxes on gains are due only when securities are eventually sold, capital gains tax can be deferred indefinitely into the future through extending buy-and-hold positions without selling for many years.

While it may seem simplistic, a buy-and-hold approach to investing, characterized by continuously holding a very high percentage of equities with only very infrequent though carefully considered buy-sell decisions, can, in my opinion, give small retail investors a slight “edge” over other investors and traders based on the efficiencies cited above.

Numerical Comparison

To gauge the impact of frictional costs on returns, let’s compare two portfolios over a 10-year period in a market that returns 10% annually:

Buy-and-Hold: Assume no turnover. At 10% annual appreciationn, $100 grows to $259 after 10 years. After payment of 15% long-term capital gains tax on the $159 gain at the end of year 10, the net portfolio value becomes $235, for an annualized after-tax return of 8.94%.
Trading: Assume 200% annual turnover, or the equivalent of two round-trip trades per year at a cost of 0.50% per round-trip. Trading costs as stated and annual taxes of 28% on short-term gains reduce the 10% annual market appreciation to (10% – 2 x 0.50%) x (1 – 0.28), or 6.48%. At this after-tax growth rate, an original $100 investment becomes $187 after 10 years.

Assuming that trading produces no pick-up in return, the frictional trading costs and additional tax lead to an inferior after-tax annual return 246 b.p. lower (8.94% vs. 6.48%) than the return available through buy-and-hold investing. On a pre-cost, pre-tax breakeven basis, the trading strategy will need to outperform the buy-and-hold alternative by a full 342 b.p. annually in order for trading to beat the buy-and-hold alternative.

As a rough rule of thumb, then, you should engage in trading only if you honestly believe that your buy-sell decisions give you at least a three or four percentage point advantage annually (and more if your turnover exceeds 200% per year) above the buy-and-hold alternative.

Self-Assessment: What’s My Trading “Edge”?

Expressed another way, the buy-and-hold versus trading decision really boils down to having an “edge” large enough to overcome the costs of trading. What in particular about you, your personality, your abilities, and your current situation gives you a competitive advantage over others in the market? Based on the information you can easily get your hands on, digest and analyze, do you have an edge over professionals who devote themselves full-time and make careers out of trading the market?

While a genius-level of business and financial acumen may not be strictly necessary for wealth-building, I would contend that your odds of becoming a successful investor or trader will be greatly enhanced if you know what your edge is. If you plan to trade ETFs or large-cap stocks over a short-term time horizon, keep in mind that you’ll be competing with Wall Street traders and hedge funds who usually have access to more up-to-the-minute newswires, customer flow information, and analytical tools than you do. Your odds of success may be slightly better in small-cap and penny stocks, asset classes that more sophisticated investors often avoid due to limited liquidity and trade size (Tim Sykes, whose claim to fame is trading his way from $12,415 to $1.65 million in just four years, day-trades small-cap stocks and is attempting to teach us all how it can be done again).

Over the years I have looked at many fundamental, technical and sentiment-based possibilities for constructing a system for beating the market, always searching for a methodology to ensure at least a 70% winning trade percentage. From one (perhaps too naive and hopeful?) point of view, given how readily availability price, volume, earnings and other quantifiable time series are, it seems that trading ought to be a “science” amenable to analysis and predictability. Unfortunately, from what I have seen so far, analytical trading rules do not appear to produce excess returns in any consistent and reliable way. Also, to date, I have yet to meet anyone who has a trading system that runs without human intervention and produces consistent excess returns. From what I can tell, trading is more like a game involving both luck and skill than a predictive science.

To Trade or Not To Trade?

Whether to engage in buy-and-hold investing or to pursue a short- or middle-term trading strategy, then, really depends on your own abilities and risk preferences. For the vast majority of people, I suspect that a buy-and-hold strategy will bear larger and more fruit than an active trading strategy. In my own case, I currently follow a buy-and-hold approach, targeting no more than 10% annual turnover to keep trading costs and taxes at a minimum.

Concurrently, I continue my search for a Holy Grail of sorts that is capable of producing winning trades at least 70% of the time (which I view as equivalent to a low-C grade, i.e., barely passing). The day I convince myself that I have a working system that meets this 70% threshold, I will begin to trade, putting real money at risk.

By the way, to anyone reading this: If you or someone you know has a trading system that produces consistent and reliable above-market returns, and don’t mind sharing a little information about it, please leave a comment. We would all love to hear about it.