5 Reasons Why Day Trading 100% of Your Money is STUPID
5 Reasons Why Day Trading 100% of Your Money is STUPID
Let’s say you know of a day trading strategy (or even swing trading) that could generate a return of 50% in a year but has tremendous risk. Would you put 100% of your trading capital which you’ve worked so hard to earn in the past several years into that single strategy? Probably not, right? Then why would you even consider day trading in and out of the market using 100% of your capital?
I get it, these high compounded returns sound tempting. If you start with $10,000, you’ll end up with over $1 million in 12 years if you returned 50% after taxes every year. But here’s a reality check: your journey from $10,000 to $1 million will be fraught with landmines and perils: a single wrong move could potentially wipe out all or most of the gains you’ve worked so hard to accumulate over the years. That’s how 50% yearly returns work. Think of this analogy: you may have attended school for 12 years and getting a 90-95% on a test is something you’d feel proud of. Now imagine going to school for 12 years and being expected to receive 95% or higher on every single test you take. If you receive anything less than 95% at any point, you must start over from year 1 again. That’s a more accurate analogy as to how 50% returns from day trading work. If it weren’t that hard and unforgiving, then everyone would be filthy rich today without doing much work!
Earning average returns of over 50% a year stock trading while everyone else is only getting 5-15% buying and holding involves exploiting serious inefficiencies in the market. Market inefficiencies do not stick around forever. Economic conditions change. Trading regimes change. Inevitable changes in market conditions do not become apparent until after the fact, but by that time when you realize it, you’ve likely sustained trading losses. Don’t underestimate the demoralizing effect that large and/or frequent losses can bring even if you’ve had a great track record up until that point (more on that later.)
Table of Contents
- 5 Reasons Why I Don’t Recommend Day Trading with 100% of your Capital.
- The Cautionary Tale of Mark Barton
- So how am I supposed to trade stocks?
- Concluding Remarks
5 Reasons Why I Don’t Recommend Day Trading with 100% of your Capital.
Reason 1: Low Margin for Error
When you buy and hold your investments, you won’t be making as many trades. Contrast that with day trading where you could be making countless trades every single day, turning over money worth several times your entire trading account. The probability for mistakes goes up the more trades you make. Sure, stop losses can limit the magnitude of your losses. But if you’re making 10+ trades every single trading day 250 days a year, you’re bound to forget or misplace a stop loss or two every now and then over the years. Miss a single stop loss and you could end up losing the gains you’ve worked so hard for months or years to make.
Think back to the past year and try to remember the number of times you’ve forgotten to lock your car, didn’t lock your house, forgot to wash your hands before eating, or sent the wrong email. Although we know we could face dire consequences if we fail to do any of those seemingly everyday precautionary tasks properly, I’m willing to bet that you’ve slipped up at least once in the last year or so. Forgetting to set a stop loss is kinda like forgetting to lock your car: you know you should do that every time and your brain puts it on autopilot but sometimes, usually less than 1% of the time, your brain slips up. But unlike not locking your car, the markets are far less forgiving (not to mention you probably have far more at stake than your car and its contents.)
Also, keep in mind that trends and other regimes in the markets also tend to persist for a long time and seem to last forever until they end very abruptly. Bubbles like the Tech Bubble of the early 2000s, the Housing bubble in 2007, the Gold bubble in 2011 are prime examples. Nassim Taleb coins the name “black swan” to describe these extreme and unexpected events that happen every once in a while in the financial markets. As I’ve discussed in the introduction, many trading systems take advantage of market inefficiencies that seem to last forever like the infamous Tech Bubble. Many traders are sucked into the same side of the trade until one day, the inefficiency disappears (i.e. the popping of the Tech Bubble) and large losses ensue.
Nassim Taleb even coined a name for this phenomenon: the Turkey Problem. Suppose a turkey is fed for 1000 days by its owner who is a butcher. The turkey concludes that butchers must love and care for the turkey’s well being with each passing day.. until the 1001st day when the turkey is suddenly slaughtered for food. Most traders, even seemingly successful ones, are sort of like the turkey in Taleb’s example. And even if you manage to get out of your trade before the market conditions suddenly reverse on you, how can you ensure you can do the same with your next trade? Or your next 3 trades in a row? Or your next 10,000 trades in a row?
Reason 2: It’s hard to regain your morale after a big loss.
Here’s a trick question: If you invest in a security or trading strategy that ends up having the following returns, what’s your cumulative return?
- Year 1: +20%
- Year 2: +15%
- Year 3: +20%
- Year 4: -50%
- Year 5: +40%
- Year 6: +40%
- Year 7: +70%
- Year 8: +50%
Doing the math, you’d think you get 314% because 1.2×1.15×1.2×0.5×1.4×1.4×1.7×1.5 – 1 = 3.14.
But notice the -50% loss in year 4 and the fact that you don’t yet know of the gigantic returns coming up in years 5-8. Knowing your extreme aversion to losses, you would have very likely bailed out in Year 4. In that case, your actual return ends up being something like: 1.2×1.15×1.2×0.5-1 = -0.17 = -17%.
Put it this way, close your eyes and picture yourself finishing year 3 with a balance of $2 million in your trading account and losing $1 million in year 4. Without knowing the returns coming up, would you be able to stomach it? Successful trading demands a ton of emotional fortitude; will you be able to stop yourself from spiraling down an emotional vicious cycle after losing the millions of dollars you worked so hard to earn over the years?
Even if you couldn’t take it and bailed out mid-year in year 4 at a -40% loss, you’d only be breaking even despite working hard as a trader for 4 years: 1.2×1.15×1.2×0.6-1 = -0.01 = -1%.
As we’ve discussed in the previous section, making a lot of trades everyday for many years exposes you to potentially large losses due to black swan events and/or trading errors. And you’d be hard pressed not to be fighting an emotional uphill battle after your first major loss.
Reason 3: Liquidity problems compound with your growth!
Having worked in the Hedge Fund industry, I’ve known managers and their friends who have earned yearly returns of 50-100% or more through day trading their personal accounts. Maybe they were lucky.. or skilled.. or a combination of both. Many skeptics would then ask if these day traders were making such huge returns, why aren’t they managing billions of dollars for, say, Goldman Sachs or Bridgewater? To put it bluntly, stock prices are a reflection of the supply and demand for that particular stock at that moment. The more money you’re trading with, the more shares you’ll have to trade each time to you go in and out of the market. The more shares you trade, the bigger the impact your trade will have on the market price of the securities. A day trader trading $1 million will end up buying higher and selling lower than a day trading doing the exact same trade but with only $50,000. So even if you get lucky and make gigantic returns on your capital for the first few years as a day trader, it’s going to be more difficult to sustain those same gigantic returns when you’re trading a larger account, even if we assume you’re lucky enough to never encounter any additional landmines that’ll derail your wealth like regime changes, black swans, etc.
If you’re still not convinced that liquidity problems are a concern the more you grow as a day trader, then consider this ludicrous example:
In 2015, the US GDP is approximately $18 trillion. Mark Zuckerberg, the founder of Facebook, has a net worth of around $36 billion at that time. Now let’s suppose you’re one of the best day traders in the world and Mark decided to retire and liquidated all 36 billion dollars of his wealth and asked you to day trade it and grow it even further. Let’s say you can generate a 50% return a year by day trading. The US GDP grows at about 6% (nominally) every year. How does the picture look in 25 years?
Mark’s net worth will be: 36 * 1.5^25 = $909042 Billion = $909 Trillion dollars 25 years from now.
The US GDP will be: 18*1.06^25 = $77 Trillion dollars 25 years from now, far less than Mark’s new net worth!
It doesn’t take a genius to know that the giant compounded returns you’re earning from day trading are completely unsustainable when you’re trading large amounts of money relative to the daily volume of your particular market. However, you will likely run into liquidity problems as a day trader far before your account reaches $1 billion when the amount of money you’re using to trade in and out becomes a substantial fraction of the total trading volume of the stocks or ETFs you’re trading. No matter how successful you are at not losing money as a day trader, lack of liquidity will likely put a damper on your compounded returns the more your account grows over the years.
Reason 4: High Frequency Trading (HFT)
Nowadays, High Frequency Traders participate in the vast majority of trades in the financial markets including the stock, bond, options, and futures markets. I’ll assume you haven’t been living under a rock the last few years but if you don’t understand what High Frequency Trading is, you can think of it as computers executing day trading algorithms, sometimes holding the stocks in time frames as short as a few milliseconds! For a more in depth introduction to HFT, please read its Wikipedia article.)
Computers can execute trades in a fraction of the time it takes you to click the buy/sell button in your online stock trading platform and can analyze far more stocks than you can in a single day (not to mention they don’t ever need to go to sleep.) The high frequency algorithms are often designed by trading companies with a budget in the million if not billions of dollars and utilizing the collective brainpower of the smartest PhDs in Finance, Economics, Statistics, Engineering, and other related fields. So if you’re competing with HFTs in your particular market, you might be able to win but the odds certainly don’t look anywhere remotely in your favor.
Reason 5: It’s just plain stressful!
The financial markets, at least for day traders, are somewhat akin to a virtual free-for-all battlefield where the majority of participants are robot soldiers (HFTs as described in the previous point.) But instead of constantly worrying about losing your life (as a solder), you’ll be worrying about losing your shirt (your life’s savings.) A soldier out on the battlefield is constantly dealing with life or death situations and his fight or flight response system is perpetually put on high gear. Similarly, day traders are constantly risking the majority of the capital they worked so hard to earn over the years and must frequently make critical decisions whether to pull out of the market or to seek better returns in different assets. When so much of your hard earned money is at stake from 9:30am to 4pm for 250 days a year, it’s no surprise you’ll be stressed beyond belief after several years of this grind assuming you even make it out with your wealth intact!
My point: day trading is an activity that requires extreme mental toughness. If you simply have above-average mental toughness, you might realistically last several months in this game but that’s usually not enough time to double or triple your wealth and earn enough to make it worthwhile. Seriously, only those with a mental toughness well into the top 1% (and borderlining on insanity) will make it through day trading consistently on a daily basis for a couple of years with their mental health intact.
The Cautionary Tale of Mark Barton
If you’re still not convinced of the financial and metal tolls of day trading, then I urge you to read about the story of Mark Barton which I’ll briefly summarize here. In the summer of 1999, volatility started to pick up before the inevitable bursting of the Tech Bubble less than a year later. Mark Barton, a day trader who had lost six figures over a period of 15 days, went on a rampage killing his wife, 2 children, and 9 people at the day trading company where he worked before shooting himself. As a high schooler back then, this was the first time I had ever heard of “day trading” though my economics teacher would explain the process in gory detail (no pun intended) when school resumed a few weeks later.
So how am I supposed to trade stocks?
I consider myself a positive thinker and don’t mean to come across as harsh as I may have seemed earlier in this article. But as someone who has been in the trenches for years, I have no desire to paint a rosy picture of one of the most competitive mediums for making money in the world: the financial markets. The first step towards learning how to trade stocks and other financial instruments is to understand the rules and realities as they really are.
Think of trading like a business.
To keep things simple, let’s say you have $1 million in assets, half of which is in cash and half is invested in your business, a large convenience store which earns you your living. Would you invest all of your remaining cash plus your profits into the store? Expanding your store would easily raise your overhead costs since you’d need to buy a new storefront and possibly hire more employees, and there’s no guaranteed the new store would even break even, much less turn a profit. In that case, it would be perfectly fine to put the remaining $500,000 in your nest egg instead of the store. However, the way many day traders go about managing their capital is akin to investing everything into their business!
The “Asset Allocation” mentality
No, I don’t mean dividing X% of your day trading portfolio in stocks, Y% in bonds, Z% in REITs and commodities. Rather, divide your trading capital into 2 boxes:
- A Passive Box
- And an Active Box
The Passive box is where you buy and hold a diversified portfolio of stocks, bonds, commodities, real estate, and other assets which collectively grows at a safe and steady rate over the years. The Active box contains the money that’s available to you for day trading.
There’s really no “one size fits all” solution for your Passive box as it really depends on your long term appetite for risk but you may want to be even more conservative than someone else at your age who is investing 100% of his/her capital in a passive strategy since you’ll need the stability to offset the volatility from your Active box. Some ideas for portfolios to use in your Passive box:
- The Permanent Portfolio
- Ray Dalio’s All-Weather Portfolio
- The traditional 60/40 Stock/Bond portfolio.
Meb Faber explores several other passive portfolios on his blog including the returns, risk, sharpe ratios, maximum drawdowns, and a whole slew of other stats!
How to manage the Active and Passive boxes.
Right now, you might be wondering what portion of your capital should you devote to your Passive box and your Active box. Again, it all depends on your risk tolerance but I think I’ll tailor Nassim Taleb’s recommendation and start with 90% Passive and 10% Active. Once you’ve day traded successfully for several months to a few years, you can gradually ramp up the % devoted to the Active portion. And at the end of the year, if you’ve made a killing day trading, your Active box will be overweight compared to your Passive box (say at 85/15 instead of your default 90/10.) In that case, feel free to rebalance and siphon off some of the excess weight in the Active box and move it to your Passive box (but I would not recommend exceeding 50% in your Active box.)
Now what if you had a poor year day trading and your final allocation came out to 95/5? Resist the temptation to raid your Passive box for more trading capital! You may only skim off this year’s gains in the Passive box to replenish your Active box (suppose your Passive portfolio returned 10% this year, you may sell and move that 10% to replenish the losses in the Active portfolio.) Some purists might even scream at the idea of replenishing a risky active portfolio with assets from a safe passive portfolio though.
Day trading is a highly competitive and perilous way of making a ton of money, so don’t underestimate the mental toll it can bring on you. To protect your sanity and to ensure that you’ll live another day to trade, only day trade with a small portion of your investment capital and leave the rest in a safe and secure buy-and-hold passive portfolio. What’s the point of making millions and millions of dollars when you’re constantly spending hours everyday worrying about protecting it with your sweaty and shaky hand on your mouse and contemplating whether you should click the Buy or Sell buttons in your online trading platform?