Trading

Advances in technology, lower commission rates, and the appearance of online brokerage firms
have enabled individuals to employ tools and systems of increasing sophistication to follow and
interpret the market. Individuals and Wall Street firms alike have embraced a new trading
philosophy, with many employing artificial intelligence programs and complex algorithms to buy
and sell huge stock positions in microseconds.

A trader is someone who buys and sells securities within a short time period, often holding a
position less than a single trading day. Effectively, he or she is a speculator on steroids,
constantly looking for price volatility that will enable a quick profit and the ability to move on to
the next opportunity. Unlike a speculator who attempts to forecast future prices, traders focus on
existing trends – with the aim of making a small profit before the trend ends. Speculators go to
the train depot and board trains before they embark; traders rush down the concourse looking for
a train that is moving – the faster, the better – and hop on, hoping for a good ride.

The bulk of trading occurs through financial institutions’ programmed systems to analyze price
trends and place orders. Emotion is removed from the buy-sell decision; trades are automatically
entered if and when specific criteria is reached. Sometimes referred to as “algorithmic or high-
frequency trading (HFT),” the returns can be extraordinarily high. A 2016 academic study of
HFTs revealed that fixed costs of HFT firms are inelastic, so firms that trade more frequently
make more profits than firms with fewer transactions with trading returns ranging from 59.9% to
almost 377%.

The impact of high-frequency trading and the firms engaged in the activity remains controversial
– a 2014 Congressional Research Service report detailed instances of price manipulation and
illegal trading methods such as detailed in Michael Lewis’ book “Flash Boys.” There are also
concerns that automated trading reduces market liquidity and exacerbates major market
disruptions, such as the May 6, 2010, market crash and recovery – the Dow Jones Industrial
Average dropped 998.5 points (9%) in 36 minutes. A similar crash happened August 24, 2015
when the Dow fell more than 1000 points at the market open. Trading was halted more than
1,200 times during the day in an effort to calm down the markets.

While few individuals have the financial ability to emulate the trading habits of the big
institutions, day trading has become a popular strategy in the stock market. According to a
California Western Law Review report, day trading continues to attract adherents, even though
99% of day traders are believed to eventually run out of money and quit. Many become day
traders due to the enticement of day trading training firms, an unregulated industry that profits
from the sale of instruction and automated trading software to their customers. The sales
materials imply that the software is similar to the sophisticated, expensive software programs of
the big traders, such as Goldman Sachs.

Day trading is not easy, nor for everyone. According to Chad Miller, managing partner of
Maverick Trading, “Everyone glorifies it [day trading], but it’s hard work…you can’t just turn on
the computer and buy a stock and hope you make money.” Day trading generally involves tens of
trades each day, hoping for small profits per trade, and the use of margin – borrowed money –
from the brokerage firm. In addition, margin traders who buy and sell a particular security four
or more times a day in a five-day period are characterized as “pattern day traders,” and subject to
special margin rules with a required equity balance of at least $25,000.

Despite the number of new day traders entering the market each year, many securities firms and
advisors openly discourage the strategy. The Motley Fool claims that “day trading isn’t just like
gambling; it’s like gambling with the deck stacked against you and the house skimming a good
chunk of any profits right off the top.”

4. Bogeling (Index Fund Investing) – A New Philosophy

Frustrated by inconsistent returns and the time requirements to effectively implement either a
fundamentalist or speculator strategy, many securities buyers turned to professional portfolio
management through mutual funds. According to the Investment Company Institute’s Profile of
Mutual Fund Shareholders, 2015, almost 91 million individuals owned one or more mutual funds
by mid-2015, representing one-fifth of households’ financial assets. Unfortunately, the Institute
learned that few fund managers can consistently beat the market over extended periods of time.
According to The New York Times, “The truth is that very few professional investors have
actually managed to outperform the rising market over those years [2010-2015].”

Influenced by the studies of Fama and Samuelson, John Bogle, a former chairman of Wellington
Management Group, founded the Vanguard Group and created the first passively managed index
fund in 1975. Now known as the Vanguard 500 Index Fund Investor Shares with a minimum
investment of $3,000, it is the precursor of many similar index funds managed by Vanguard –
including the largest index mutual fund in the world, the Vanguard 500 Index Fund Admiral
Shares, with assets of $146.3 billion and a minimum investment requirement of $10,000.

Despite the industry skeptics about index investing, Bogle’s faith in index investing was
unshaken. The following statements express his views, and is the basis of his book, “The Little
Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market
Returns.”

 Investors as a group cannot outperform the market because they are the market.
 Investors as a group must under-perform the market, because the costs of participation – largely
operating expenses, advisory fees, and portfolio transaction costs – constitute a direct deduction
from the market’s return.

 Most professional managers fail to outpace appropriate market indexes, and those who do so
rarely repeat in the future their success in the past.

The fund was initially ridiculed as “Bogle’s Folly” by many, including Forbes in a May 1975
article entitled “A Plague on Both Houses.” (The magazine officially retracted the article by
Forbes writer William Baldwin in an August 26, 2010 article.) The Chairman of Fidelity
Investments, Edward C. Johnson III, doubted the success of the new index fund, saying, “I can’t
believe that the great mass of investors are [sic] going to be satisfied with just average returns.
The name of the game is to be the best.” Fidelity subsequently offered its first index fund – the
Spartan 500 Index Fund – in 1988 and offers more than 35 index funds today.

With the success of index mutual funds, it is not surprising that exchange traded funds (ETFs)
emerged 18 years later with the issue of the S&P 500 Depository Receipt (called the “spider” for
short). Similar to the passive index funds, ETFs track various security and commodity indexes,
but trade on an exchange like a common stock. At the end of 2014, the ICI reported that there
were 382 index funds with total assets of $2.1 trillion.

Multiple studies have confirmed Bogle’s assertion that beating the market is virtually
impossible. Dr. Russell Wermers, a finance professor at the University of Maryland and a
coauthor of “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimating
Alphas,” claimed in an article in The New York Times that the number of funds that have beaten
the market over their entire histories is so small that the few who did were “just lucky.” He
believes that trying to pick a fund that would outperform the market is “almost hopeless.”

Some of America’s greatest investors agree:

 Warren Buffet. The Sage of Omaha, in his 1996 Berkshire Hathaway shareholder letter, wrote,
“Most institutional and individual investors will find the best way to own common stock is
through an index fund that charges minimal fees.”
 Dr. Charles Ellis. Writing in the Financial Analysts’ Journal in 2014, Ellis said, “The long-term data
repeatedly document that investors would benefit by switching from active performance
investing to low-cost indexing.”

 Peter Lynch. Described as a “legend” by financial media for his performance while running the
Magellan Fund at Fidelity Investments between 1977 and 1980, Lynch advised in a Barron’s April
2, 1990 article that “most investors would be better off in an index fund.”

 Charles Schwab. The founder of one of the world’s largest discount brokers, Schwab
recommends that investors should “buy index funds. It might not seem like much action, but it’s
the smartest thing to do.”

Adherents to index investing are sometimes referred to as “Bogel-heads.” The concept of buying
index funds or ETFs rather than individual securities often includes asset allocation – a strategy
to reduce risk in a portfolio. Owning a variety of asset classes and periodically re-balancing the
portfolio to restore the initial allocation between classes reduces overall volatility and ensures a
regular harvesting of portfolio gains.

In recent years, a new type of professional management capitalizing on these principals – robo-
advisors – has become popular. The new advisors suggest portfolio investments and proportions
of each allocated in ETFs based upon the client’s age and objectives. Portfolios are automatically
monitored and re-balanced for fees substantially lower than traditional investment managers.