Invest in an Index or Trade?

· 8 min read
Invest in an Index or Trade?

What do want long term?

Getting started in any endeavor can be daunting and trading or investing is no different. You are probably wondering to invest or trade? There are hundreds if not thousands of decisions to make that could all impact the outcome of your decision to plunge into the markets head first with your hard-earned money. You've heard it time and time again... 9 out of 10 retail traders fail to make money, end up either in the red financially or burn themselves out physically and emotionally.

Before you consider deep diving into technical analysis, fundamentals, techno-fundamentals, quantitative mean reversion strategies (I'm trying to prove a point here)... you need to sit down, look yourself in the mirror and ask yourself a few serious questions. Do you know what trading REALLY involves and the same for investing? Avoid joining the herd and throwing money at the market like a giant open air casino - there is a way to win in the market and this manifests differently for anyone who wishes to jump in. Step one of the evolution is knowing what it's really like to trade when compared to investing.

Remember that although the goal is the same (making your money work for you) choosing whether to trade or invest is a life changing decision. That can be a liberating or debilitating depending on who you are.

He who knows others is wise; he who knows himself is enlightened.
― Lao Tzu

1. To Invest or Trade

Before you begin on your quest for market knowledge, ask yourself, what is the difference between investing or trading? There is a clear distinction between the two. An investor typically approaches the market with a long term time horizon and buys financial instruments irrespective of short term moves. Investopedia describes an index investor strategy as:

"Index investing is a passive strategy that attempts to generate similar returns as a broad market index. Investors use index investing to replicate the performance of a specific index – generally an equity or fixed-income index – by purchasing exchange-traded funds (ETF) that closely track the underlying index. There are numerous advantages of index investing. For one thing, empirical research finds index investing tends to outperform active management over a long time frame. Taking a hands off approach to investing eliminates many of the biases and uncertainties that arise in a stock picking strategy".

If you find this description if index investing confusing then please click here. This video describes it in under 2 minutes.

A trader, although similar to an investor, typically operates in shorter time intervals hoping to get the maximum amount of return in the shortest space of time. When I think of investing I liken it to building long term wealth using index funds that follow the general return of the market, index investments follow the ‘efficient market hypothesis’. Summarised, this means investors are happy to get returns in line with that of the general market. Typically this warrants a 7-10% return per year on average. Deciding on to invest or trade ultimately comes down to your time restrictions and commitment to learn.

To invest in index funds one needs to pick a small basket of assets and allocating a percentage of your wages or income to the strategy every month. The monthly buying of your desired mix of assets is done irrespective of whether the market is up or down. Typically, index investing means owning a basket of assets such as Index Funds, Bonds, Utilities or even Gold in some cases.

Sounds pretty boring doesn't it? Good! Trading and investing should be boring, if your getting excited about it then your probably going to lose money, we will get into psychology later - in fact most of this site will talk about trading psychology. For now let’s help you find your stride and figure out what kind of market participant you want to be
potentially. Personally, over half of my personal wealth is put into long term index funds! This has helped me get mortgage free at a young age and not rely on debt to acquire other assets.

The Pros about being an Index or long term investor are:

  1. Less time requirements
  2. Psychologically less demanding
  3. Consistent Results
  4. Low maintenance
  5. Easily executed
  6. Lower Risk Profile
  7. Compound interest
  8. Perceived certainty and ability to plan and forecast

The Cons about being an Index or long term investor are:

  1. Inability to pick out-sized winners (think Google, Amazon)
  2. Small upside potential with large draw-down potential in ‘Black Swan’ event
  3. Inability to time market
  4. Current market prices and conditions
  5. Higher gains in smaller time frame

The above also illustrates the associated upside in trading. Successful traders can make significant profits in far less time.

Let’s take a look at these two scenarios

i) Typical Market Returns for Index and Long Term Investments

Using compound interest and a 35-year time horizon (you started at 30 and want to retire at 65). You invest $50k into the market adding $10k in savings per year. This should be possible for most of those in Ireland and the US, if not then you have bigger problems than investing and need to refocus your efforts and prioritize saving, read our blog on the matter here ‘An Exercise in Discipline: Savings’. In our hypothetical case let's imagine you buy the an Index fund such as the SPY . The average return would be between 7-10% year on year. Compound this over 35 years and the numbers are astounding! Chart courtesy of Macrotrends.

Invest or Trade

You now have a pension of $4.4 million. Could you live on that? Or the potential $400k per year it would generate? I certainly hope so. If you find this useful or are curious on how it was calculated, please use the compound interest calculator found here .

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ii) Trading Returns using the same amount of money.

If you think that sounds good, let’s think of Scenario 2. I’ll use one of my favorite traders as the example Mark Minervini, who by the way has the absolute best books ever written on the subject "Trade Like a Stock Market Wizard", do yourself a favour, stop reading this blog, learn the basics on trading and look this guy up. Mark has a habit of returning 100%+ returns each year. So let’s use our previous example with these numbers as a guide.

Using Mark’s worst year as our yardstick we would be the new billionaire kids on the block. That’s right. $2.4 Billion would be our pot using our $50k stake over 35 years! Not as cool as our $400k in the bank, but pretty close.Professional traders who have graduated from the multiple years of losses can sometimes attain these levels of wealth.

In summary, trading is a far more difficult and riskier endeavor (mostly when getting started) but if learned and mastered can yield significantly larger gains and result in wealth beyond what most people can grasp. Those who persist and develop the tools required for this feat are rewarded exponentially. The truth is however that it’s hard. Really hard. It involves hours of time, lot’s of losing with grace, learning from defeat and accepting things that are outside of your control. One of my favorite sayings from Richard Branson is .."It took me 20 years to become an overnight success".

The trading curve takes longer, is more time consuming and requires a high drive and focus. You really need to be understand the commitment difference when deciding to invest or trade.

2. Time Commitments

Now that you know what’s at stake, think about it logically. Do you think it is easy to get 100% gains per year? In any other profession such as lawyers, doctors, psychiatrists and those valued and paid accordingly in society – it takes years. In fact, it takes some specialised professionals 15+ years to get to the upper crust of their profession and still be paid a fraction of what a top trader makes. Do you think accruing $2bilion would be any different? Let me help you out here, it certainly is not.

If you want to trade as opposed to invest it takes hours of research, watching the charts, understanding what matters (super important as I’ve spent years wasting time on BS) and being able to apply these principles in real time.

It always surprises me when friends or family say "you're lucky" after seeing the fruits of trading. The truth is I have missed countless nights out, moments with those I care about and other events that most would consider 'fun'. the truth is, I am comfortable with acknowledging that and still want to learn and know more. Trading is like any profession that requires a high degree of precision and skill.

If a surgeon was trained on Youtube would you let him slice you open? I certainly hope not. Trading is no different. It takes years of practical experience to understand the theory and put it together in the real world. To invest or trade might seem like a simple question to most, but it holds many, many underlying layers.

As a long term index investor. Expect to put in 1 hour per month. As a trader, sometimes 10 hours of my day goes into learning more, developing myself and watching the charts. It's a lifestyle change!

3. Expectation vs Reality

If you haven’t been scared shitless from this post, perhaps you think its time to get stuck in. That’s great and I commend your animal spirits for taking up the challenge. If this is the case then I urge you to set yourself up with a realistic approach to trading and perhaps check through these few points before committing:

How much money do you expect to spend before calling it quits?

How long do you think it will take to become consistent? How are you validating that?

How much time will you commit to this on a daily basis?

Do you really want to invest or trade?

Do you want to do this full time? Why, have you truly thought about what this means?

What has drawn you to trading?

Do you have a gambling propensity?

Over the next few posts we will explore these topics in greater depth. Very few market participants think of the true demands trading will place on them. The reality is that trading is at the Apex of capitalism. At this Apex we found all those at the top of the food chain. It’s competitive, it’s difficult and it can be lonely. Facing reality is everything. To invest or trade is however much better than just letting your cash sitting in a bank devaluing due to inflation and fees.

Does trading still sound interesting? If the little voice inside your head is saying “hmmm maybe it…” NO, save yourself.

If you are aware of these risks, have contemplated the rewards and what’s involved, then its time to get learning. Feel free to download our trader checklist which lays out the approach that worked for me. I’ve cut out the 150+ books and 8 years of time wasting and boiled it down to some basic requirements on our check list. Sign up, download and get in touch. I'm happy to help where I can.

The nature of the game as it is played is such that the public should realize that the truth
cannot be told by the few who know.
― Jesse Livermore, Reminiscences of a Stock Operator

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If you are more conservative and want to find out more about how to build a basket of ETF's or Index funds, please get in touch!