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What Are The Tradeoffs For Trading Stocks?

“Four ‘Bull Market’ Strategies” “Earnings Season Trading Opportunities” “Buy stocks now, and you’ll be leaving the ‘totally lost’ investors in the dust” These are just three headlines I grabbed this morning from popular financial Web sites. Three among the many exhorting people to trade – or more accurately, speculate – because this thing or the…

“Four ‘Bull Market’ Strategies”

“Earnings Season Trading Opportunities”

“Buy stocks now, and you’ll be leaving the ‘totally lost’ investors in the dust”

These are just three headlines I grabbed this morning from popular financial Web sites. Three among the many exhorting people to trade – or more accurately, speculate – because this thing or the other is happening in the market.

Apparently, as I write this, the mood is “buy, buy, buy.” Nobody wants to feel they missed out – although the headline writers aren’t your financial advisors and have no responsibility of your portfolio’s welfare – but that little fact gets overlooked in the rush to speculate on what’s hot now.

There’s a pretty good quote that I ran into twice this week. It’s from Paul Samuelson, the first American to be awarded a Nobel Prize in economics, which he won in 1970.

“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

Unfortunately, a disciplined investment strategy doesn’t make for fun cocktail party chatter or high-energy segments on financial TV.

Plenty of books, Web sites and stock-trading systems try to capitalize on people’s interest in finding the next hot stock – or, just as often – beating the crowd to the exits when markets seem poised for a downturn.

Sadly, these systems often make more money for their purveyors than they do for the poor souls trying to make a buck by following the system’s rules.

One big attraction for many stock pickers is the idea of “growth.” It sounds great, doesn’t it? Who doesn’t want stocks that grow?

Unfortunately, growth, which sounds sexier than “value,” under-perform growth stocks over long periods of time. This has been researched extensively by Eugene Fama and Kenneth French, who reviewed data on growth and value stocks going back to 1927. You can read more about that out-performance in an article I wrote for Seeking Alpha.

But “growth” sounds more exciting. The growth stocks tend to be the ones getting news coverage. Right now, think Facebook (FB), LinkedIn (LNKD) or Edwards Life Sciences (EW).

There are plenty of systems out there that claim to teach people how to hunt for stocks with explosive profit growth, and then buy them at precise buy points only when the market is trending higher. Most of these systems seem logical enough. Followers are often given very specific buy, hold, and sell rules instructions sometimes lead to investment holding periods as short as just a few weeks or even days or hours, in some cases!

With nearly 6,000 stocks listed on the NYSE and NASDAQ combined, the implementation of these systems can be difficult for retail investors – because guess what? Emotions get in the way. Life gets in the way. Maybe you don’t have all day to sit in front of your computer screen, waiting for exactly the right moment to hit the buy button.

There are a few big problems with trying to use this type of system that has you picking growth stocks:

  1. Few people have the discipline to follow a trading system to the letter. As I learned when I worked at Investor’s Business Daily, which promotes the CAN SLIM system, people tend to bolt additional parts onto a set of “rules.” Pretty soon, there’s a Frankenstein monster of Fibonacci retracements, cups and handles, Bollinger bands, 10-minute timeframes and who knows what else? Turns out, those additions don’t improve a trading strategy, as much as create a muddled mishmash.
  2. Many people use trading strategies as a substitute for disciplined investing with a particular objective. Think you can trade small-cap, U.S. growth stocks all the way to a secure retirement? Maybe that’s a plan, but only if you get insanely lucky. Most of the time, you’re adding a ridiculous amount of risk to your financial situation, while putting yourself at the mercy of the vicissitudes of a very narrow group of stocks.
  3. I’ve never seen a trading or speculating system – even those that bill themselves as “investing” systems – that’s able to deliver the return a particular individual needs, commensurate with the appropriate risk level. Want to trade large U.S. growth stocks? That’s pretty risky: You’re focusing on one particular type of asset, and throwing your lot in with that. It sounds good to invest in growth stocks, but what about when growth is out of favor? If you don’t correctly time your stamped into cash, you may be out of luck.
  4. Speaking of that stampede: You have to be right twice – once when you sell and again when you buy back. Sure, the system may give you some technical signals – but the trick is to use them correctly! Our minds play tricks on us, and it’s tough to admit losses or pocket gains without annoyances like hope, fear and greed getting in the way!

When trading one particular asset class, such as large-cap U.S. growth stocks, you ignore all the opportunities that exist elsewhere. While the S&P 500 suffered through a “lost decade” between 2000 and 2009, small-cap value stocks from other developed markets soared, as seen in the illustration below:

In some cases, an actively managed mutual fund can illustrate potential pitfalls of a trading strategy. Let’s examine the CAN SLIM Select Growth Fund (CANGX), run by NorthCoast Asset Management. The fund aims to apply the CAN SLIM investment methodology in a rules-based system.

The steps, as laid out by the asset manager, are:

  • Analyze market environment to determine proper equity exposure (Note: This is only of limited use, as the fund’s mandate is to invest in U.S. stocks, regardless of the market environment.)
  • Select the best risk-adjusted CAN SLIM growth stocks (So you’re limited to growth stocks, which underperform value, over time. Sure, plenty of funds are mandated to hold one or the other, and that’s fine. Just be aware of the inherent limitations.)
  • Manage risk daily by monitoring positions and scaling to cash. (In other words, your trading costs will be higher than those of a U.S. large-cap or mid-cap index fund. That’s borne out by a net expense ratio of 1.39%.)

Adding insult to injury, its performance since its 2005 inception, on an annualized basis, has lagged the boring old S&P 500 index.

The fund has a mid-cap tilt, with 40% of holdings classified as mid-caps. For that reason, it’s worth a comparison with the iShares Russell Mid-Cap Value ETF.

CANGX not only has lower cumulative return compared to IWS, but it also has a lower risk-adjusted return as measured by the Sharpe Ratio and the Sortino Ratio. Sharpe Ratio measures the return a fund generates given the volatility, while the Sortino ratio measures the return the fund generates given the downside volatility. In both cases, a higher ratio means the fund is performing better on a risk-adjusted basis.

An emphasis on trading, rather than a simple index or passive strategy, can easily result in extra costs and lower return. That’s true even in the case if you try to simplify your experience by owning a fund, rather than trading individual stocks.

Compare CANGX’s annual net expense of 1.39% with the index-tracking IWF, whose net expense ratio is 0.25%. The underperformance of the CAN SLIM fund has something to do with fees, but dividends  – or the absence thereof – also loom large.

Both CANGX, and the CAN SLIM ETF, FFTY, have very little dividend income, compared to index investing. CANGX is currently yielding 0.14% while FFTY is yielding nothing. On the flip side, IWS yielded 2.12% in the last 12 months.

Dividends are a big part of annual performance for stock markets, and should not be overlooked. From 1950 to 2009, average annual stocks market returns is exactly 7.0% and when you break down the 7% annualized return, roughly 3% is from price appreciation, 2% from inflation, and 2% is from dividends. Dividends represent 29% of overall investment returns. To  take that away from investors – or simply overlook it, and focus solely on price appreciation – is detrimental to any investment strategy’s performance.

Lastly, at 277% turnover rate for CANGX the fund can cost investors dearly when tax seasons comes, due to all the short-term capital gains being taxed at ordinary income rates. It’s easy for traders to ignore the effects of taxes, but it’s a key component of one’s overall financial picture, and can’t be overlooked because it’s inconvenient or the trading-strategy purveyors are simply ignorant of tax ramifications.

In summary, high expenses, low dividends, and high turnover rate are hurting adherents of trading systems. These disadvantages hurt investors, relative to a simple indexing strategy.

Now, it’s true that implementing a trading strategy on your own, without turning to an actively managed mutual fund, may remove some of the expenses, although trading costs, capital gains and opportunity costs could still sink your performance, when compared to an index or passively managed fund.

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