Let’s say you’re the best trader ever…

…would it be worth trading frequently even if that were the case?  (it probably isn’t, sorry)

We have lots of friends in the hedge fund and asset management arena at my shop, and we have a great deal of respect for the work that they do and the insights they share. But we typically don’t allocate to them for our customer accounts because, as fiduciaries, we just can’t make the math work – despite their gross returns.

My colleague Michael Batnick, director of research at Ritholtz Wealth Management, took a look at just how fantastic your gains would have to be above and beyond the market’s return to make weekly trading worthwhile. It turns out that, over the long run, you’d have to be a Superman in the market, capable of something utterly incredible – and even then it might not be all that helpful. Frequent trading in a taxable account is not going to do you any favors, no matter how good you are. 

Below is a guest post from Michael Batnick that originally appeared at his Tumblr last night. It’s an incredibly important insight… – Josh

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Are you the best trader ever?

Imagine you’re John Templeton, George Soros, and Paul Tudor Jones all rolled up into the worlds greatest trader. Since 1990 you were able to beat the S&P 500 every year by forty percent. If the market was up 10%, you were up 14% and if the market fell 10%, you were down only 7.15%

Beating the S&P 500 in any given year is a challenge. Beating the S&P 500 every year for nearly a quarter century is extraordinary. Beating the S&P 500 every year for nearly a quarter century by forty percent is all but impossible.

Typically when people look at performance numbers for active trading strategies, they look at gross returns and don’t pay attention to taxes. I wanted to see just how damaging paying taxes on short term gains would be to a taxable portfolio.

Going back to 1990, had you invested $10,000 in the S&P 500 and held on through 2013, you would have amassed $76,266 (assuming taxes are paid annually on dividends*).

If the best trader of all time invested $10,000 in 1990 and beat the S&P 500 every year by forty percent, net of taxes he would have amassed only $69,197, less than the buy and hold investor (not even factoring in trading costs).

These numbers are pretty astounding but I want to emphasize that the point of this exercise is not to suggest that trading is for fools, or that it can’t be done. I want to demonstrate that taxes on short term gains can be a huge impediment to accumulating wealth. Had the best trader of all time achieved these same returns in a tax deferred account, he would have amassed almost $192,000!

Nobody can argue that buy and hold isn’t rife with drawdowns, does nothing to stroke your ego and is extremely boring. However, for taxable accounts, you’d be hard pressed to find a better alternative.

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Josh here – No one is going to tell you that; your online broker wants you playing the game, with as many buys and sells each month as possible. The media and the asset management industry all want you to strive for outperformance – because that’s a higher margin pursuit and one that keeps you engaged, paying and clicking. It’s up to you to decide whether or not this activity is enjoyable enough as a recreation to make it pay off – because financially it probably won’t. 

Source:

Follow Michael on Twitter at The Irrelevant Investor

* for dividend taxation, Michael used 40% – the highest tax bracket until 2003, the date at which the Bush tax cuts were enacted. Since then, dividends have been taxed at 15%, which is reflected in the total here. For the trader’s short-term capital gains, he assumed a tax rate of 30% – which is a middle of the road tax bracket for most active traders.