Investing Basics: Trading or investing, which one’s better?
When seeking financial independence, which is the better way of generating wealth? Is it investing or is it trading? Guest post from Humbug – a contestant in The Great British Trade Off
This is a subject that I’ve recently given a lot of thought to. As the investor I was the losing contestant in the Great British Trade Off, which apart from private pain, is also public humiliation
Until I became the investor in The Great British Trade Off, I’d always been a trader; show me a profit and I’d want to take it.
Down the years this policy has served me quite well and whilst not every deal was profitable more were than not.
This holds true for both property and stocks and shares. Taking property first of all. In the eighties for a short time I flipped a number of Victorian terraced houses (bought, renovated and then sold). In round figures, they cost me fifty thousand pounds, the renovations were five thousand and they sold on for sixty thousand,
The margins were extremely tight and the whole operation lived or died on speed; get in, get out, get em sold. The target was twelve weeks from starting work to handing the keys to the happy new owner.
After all the ‘in and out costs’, the bank charges and the tax were taken out of the five thousand gross profit, I was left with a net profit of around two thousand pounds.
‘Instant gratification in the shape of a Porsche, great cars but stupid, I wish now I’d taken the long view’
Now, money then is different to money now because of inflation, two thousand pounds in 1985 would be worth about six thousand pounds now.
So yeah, spinning houses at the equivalent of £6k a pop was a nice enough little tickle, but it wasn’t a kings ransom.
Now here’s the thing. For sure this is a little bit of a contrived figure, but it illustrates the point fairly I think. Had I carried on trading houses for a profit of £6k a time, at the rate of 4 a year for the 33 years since 1985 I’d have made £792k.
However, those little houses are now worth £300k each.
So if I’d invested rather than traded, I’d have made more money with dramatically less work. Say I’d only kept the first four and rented them out, they would have cost me £220k and they’d be worth £1.2m now.
The rent would have covered the maintenance and the mortgage (with a surplus in the later years) and for the last eight years the houses would have been mortgage free.
In today’s money the rent from each house would be £1000 a month net, so £48k a year for the four. In the eight years since the mortgages would have been paid off that’s a gross £384k.
No capital gains to pay until the houses are sold, allow 40% income tax on the rents so investing would have produced £1.210m against trading producing £792k.
Having just written all this, the question I’m asking myself is why didn’t I keep the first four houses?
The answer is I was stupid. I was too interested in having a good time and spending my money as fast as I got it in those days. Instant gratification in the shape of a Porsche, great cars but stupid, I wish now I’d taken the long view.
These are only ‘back of a fag packet calculations’ but I think they clearly show that property is a long play. In the short term there is more money to be made trading property, but over a twenty five year mortgage cycle investing is far more profitable for a fraction of the work.
What about the Stock Market?
Fagin and I were engaged in a public competition on the private investment website diyinvestor.net, the idea being to see is investing in the markets more profitable than trading them over a five year time frame.
As you may know I’m Humbug, the investor, and after two years I lost badly; the losses I suffered in the early months of the competition were largely of my own making.
I struggled to adapt to the different disciplines needed for investing as opposed to those of trading which I was used to.
I’d hoped the second year was going to be, but barring a catastrophe for Fagin where he blows up his account, trading will beat investing over a five year time frame given the relatively small (one hundred thousand pounds) of opening capital we both had.
‘£100k compounded up at 15% a year becomes £6.4m in 30 years’
I wasn’t being defeatist, or wanting to change the rules of The Great British Trade Off, but the five year period we settled on isn’t long enough for the benefits of investing to shine through or for the drawbacks of trading to become apparent.
I’ve recently been looking in some detail at compound interest. Albert Einstein wasn’t wrong when he said it was the greatest force on earth. If you get your calculator out you’ll quickly see what I mean; £100k compounded up at 15% a year becomes £6.4m in 30 years.
15% a year, year after year is a big ask, but John Lee (Lord Lee) of Investors Chronicle fame has achieved an average of over 20% for over twenty years, so it can be done.
Just like property, for the stock market in the early years of a comparison, I think trading will easily beat investing if the opening capital is less than (say) £5m. Because with only a small capital base, for an investor the benefits of compounding returns are still insignificant in absolute money terms and the smaller the sums involved the easier it is for a trader.
For the investor, 15% of £100k is only £15k; a good trader is likely to earn double that, maybe more. Indeed the trader is likely to be well ahead for about twenty five years only then is the balance likely to start shifting.
If the trader can bang in 30% a year in compounded gains for ten years he will have turned his £100k into £1.6m (and how brilliant is that?) But from about there onwards he starts to run into difficulties with the size of his trades. A good trader will only open a position when conditions are right for him, so there are only so many trades a year of interest to him.
How many is so many? Well who knows, it will vary from trader to trader and week to week. I would think that Fagin probably took about 75 trades a year in the Great British Trade Off.
With this few opportunities on offer, each trade has got to be a significant percentage of capital to be worthwhile. Also a trader needs to be nimble and be able to get into a position quickly and easily and much more to the point out even faster if things are going wrong.
So liquidity is paramount. The exchange market size, in other words the number of shares you can easily trade varies from company to company. Generally speaking the larger the company the more shares you can automatically buy and sell.
But the amounts are smaller than you might think. At the time HSBC was the UK’s largest company at a £139 billion capitalisation, its market size was £21k.
‘you’ll move the market against you on both the way in and the way out’
Evraz PLC who Fagin bought into was a £7 billion company with a market size of £14.7k. He bought three times that amount utilising about 30% of his capital.
In good times you can just about always buy or sell these kind of amounts in large companies without difficulty, but even here it might not be so easy to get out if there were big problems.
If one party wants to sell then someone else has to want to buy and when there’s a company specific or general market crisis, buyers are thin on the ground.
Imagine how much worse things could be when you’re trading 30% of (say) £1.6m and trying to get out of half a million pounds worth of shares that nobody wants. You’re going to take a spanking.
That situation becomes more and more difficult for a trader the more capital he has, you get up to those sort of sizes and you’ll move the market against you on both the way in and the way out.
Also when you’re trading inside or close to inside market size no one takes any notice of you, you can nip in and out as you please. Get up to half a million or a million pound trades and clever people in big banks and hedge funds will start to take an interest in you and look to challenge what your doing. They’ll want to take your profits away from you, so they’ll work out things like where your stop is likely to be and deliberately make life difficult for you.
By contrast life for the investor with its much slower pace remains just about the same no matter how much capital is employed, sure things won’t always go well, but he won’t face the challenges the trader does. The only thing is that once you get up to a serious number of millions, natural caution may start to take hold and preserving what you have may be more important than getting more. Nice problem to have.
So my view is that exactly like property, in the stock market a trader will easily make more money from a small capital base in the early years, but that as time goes by he will face difficulty with market liquidity and the investor will slowly reel him in.