Stay invested for making money

Otherwise, figure out the impact of taxes and brokerage costs if you think your trading or stock-picking skills can beat the index

Barry Ritholtz is a financial columnist for the Washington Post and also the CIO of Ritholtz Wealth Management. He wrote an interesting series of columns recently. He took two columns to compare returns for a great trader versus a passive index investor with a systematic investment plan (SIP). A third column looked at a good timing strategy versus the same sort of SIP. A fourth column looked at great stock picking results versus SIPs. These were US-specific. The tax element is different and so are the specifics of returns. However, the points raised are globally relevant and worth consideration even for a desi retail investor.

The calculations showed that a trader who outperformed the passive strategy consistently by as much as 4 per cent per annum would only break even versus the passive American investor. This is due to the impact of short-term capital gains tax. Tax mops up about one-third of annual trading profits, while an SIP has zero tax and steady compounding. If you factor in brokerage costs, the differences are even more in favour of the SIP.

There are major differences in the two tax regimes. India has a lower effective short-term capital gains tax rate, zero tax on long-term capital gains and zero tax on share dividends (the US has taxes on both). There are also big differences in the carry forward of speculative losses and the treatment of derivative profits and losses as business income and expense.

But the principle is the same: a trader must outscore a passive player consistently, by very large amounts to beat the passive systematic investor in the long-term. In fact, the specifics of Indian market returns and Indian tax policy implies that the Indian trader needs to beat the India index returns by even larger margins per annum.

The WaPo timing strategy assumed that the "timer" buys the index after steep corrections. This is sensible on the surface. But it doesn't work well compared to a SIP. The flaw is that there are long periods when a timer doesn't add to equity exposure while waiting for the next correction.

Comparing the returns of the great stock-picker is the most difficult and subjective. The columnist assumed that the stock picker "somehow" bought five great stocks in Apple, Google, Tesla, Netflix and Chipotle at the respective IPOs. Each of these stocks has given returns of over 1,000 per cent (absolute) since its IPO.

However, each of these stocks has also seen multiple periods of deep corrections including massive single session losses and big draw-downs across several months. The columnist's contention is that few stock pickers have the nerve to hold through such steep losses.

It is also impossible to create a mechanical strategy that locates big winners at the initial stages, as Ritholtz generously "allows" pickers to do. The stock picker would certainly need to have a lot of nerve to hold through big corrections and again, this is difficult to "program" into human beings. Any stock picker will also make some errors and that will pull down overall returns as well.

The timer is the most interesting case. In the assumed example, the timer buys only after big corrections. This loses compared to a systematic monthly buy and hold because the timer doesn't commit enough money over a sufficient length of time. Other variations on timing strategies may work better. For example, the timer could use a SIP with a method of committing larger amounts at one go if there's a correction. Say, a standard SIP commits "x" amount invariably per month.

A "timing plus SIP" method could match the commitment of x in ordinary months and commit say, 2x or 3x in months where there has been a big correction. If such a strategy is used, normal compounding is helped along by lower averaged costs. This will beat a normal SIP and it can be mechanically programmed and implemented. This is in fact, one of the few mechanical strategies that may beat a standard SIP.

The lessons from Ritholtz's columns are simple and global. First, investors need to understand it pays just to stay continuously invested and let the power of compounding work. Second, figure out the impact of taxes and brokerage costs if you think your trading skills or stock-picking skills can beat the index. Those costs will be considerable for active traders and this will favour the SIP.