Do You Really “Earn” Your Investment Income?

by Mike Holman

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I met an acquaintance a while back who told me that he was day trading while in between jobs. I was quite curious about his strategies and how much he was making but he wouldn’t give me many details and I didn’t know him well enough to push. He did tell me on several different occasions though that he “was making good money” with the day trading.

The reason I wanted to know what kind of returns he was getting was because I was skeptical that he was doing as well as he said he was, and also because I wanted to point out to him that in a year when the market goes up around 18% as it did that year, it’s not hard to “make good money” by doing pretty much any kind of investing.

Stock markets go up and down over time. The main reason people invest in them is because they believe that over time, the stock market goes up more than it goes down, which has held true since the beginning of time (or stock markets). The reality is that nobody can accurately predict what the market is going to do any given year. It might go up 10%, it might stay flat or there could be a big loss. The phrase “A rising tide floats all boats” applies very well to equities. In years when the market gives double digit returns, everyone looks like a great investor. In years when the markets drop, almost everyone is a loser.

My point is that someone who is invested in equities in a market that goes up 10% and gets 10% on their investments didn’t really “earn” anything because of their investing prowess since they only got the market return which is easily obtainable with a basic ETF or index fund.

I think that all active investors should measure how much value they are adding by choosing their own stocks or mutual funds by comparing their returns to some kind of index or passive alternative based on an index such as an index fund or exchange traded fund. This would apply regardless of if you are trading stocks hourly or buying stocks for the long run (hello Siegel!).

For example if you trade your own stocks or bought active mutual fund and got a 10% return in a year, that sounds pretty good but is it? Did you really “earn” 10% by picking your own investments? What if the index returned 8% that year. Then I would say that your stock picking really only earned 2%, not 10%. Conversely, what if the index returned 12% that year. I would then say that your active management cost you 2% of your potential portfolio that year.

To accomplish this comparison if you trade stocks and/or buy mutual funds is to find an ETF that covers similar stocks. If you are an investor who likes to buy large American companies then you might want to look at an ETF like Vanguard Large-Cap ETF (VV) or even just look at the entire American stock market with Vanguard Total Stock Market Index VTI (the “American” is silent). ETFs and index funds charge a small fee so they will never match the index but should be pretty close.

Another thing to think about is the absolute amount of dollars you are earning from your investments.  If you spend a lot of time trading stocks or planning investments and you are really only earning say a 2% premium return on your investments per year then how does that work out per hour?  If you are investing $10 million dollars then 2% is $200k which is well worth the effort.  But if you only have a couple of hundred thousand then 2% is only $4k which is not a lot of money if you spend a lot of time on your investments.

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{ 20 comments… read them below or add one }

1 MillionDollarJourney

Hey Mike, great post. As i’m young and going for the gold, I fall into the area of trading too often. I may be doing alright thus far, but it takes a lot of work and research. Picking stocks has to be something that you love to do, if not, then indexing is the best bet.

2 FourPillars

Thanks MDJ.

I don’t think there is anything wrong with using at least part of your portfolio to pick stocks if it’s a hobby, but like any hobby you should know how much it costs you (or how much you make!).

Mike

3 Emily

Excellent post full of good points. It sure is easy to feel great about investing when the market is good all around. Anyway, I had to say that I seriously laughed out loud at “the American is silent” :)

4 FourPillars

Thanks Emily – I would assume that Vanguard ETFs are owned almost exclusively by Americans so it makes sense to leave the word out of the name.

Mike

5 telly

Great post Mike. Your point about 2% for a small portfolio is especially interesting considering ~95% of our portfolio is indexed.

I know I’ve got a bit of ‘gambler’ in me so I generally stick with index funds.

As for the small amount I do ‘play’ with, most of my picks have not faired well (and lucky for me it is painfully obvious so I don’t even need to do the math ;) ).

6 Canadian Capitalist

I’d go even further. Instead of comparing just her stock-picking prowess with an equity index, an investor should compare the performance of her total portfolio against a diversified portfolio of many asset classes that match their capacity and tolerance for risk.

The reason is that if you choose to hold more (or less) equities than the benchmark that is suitable for you, it is also a form of active management. If you hold 100% equities and made 0% and the equity benchmark returned -2%, did you win? I’d say it depends on the performance of the diversified portfolio which may have returned 4%.

7 FourPillars

Telly – thanks. You should stick with your purchases – I know exactly what it feels like to buy something and then watch it go down but if you bought for the long term then stick with it.

I’ve been pretty disciplined about not buying individual stocks except for my leverage portfolio (where I need to control the dividend yield) but it sure is tempting sometimes – especially when I read one of Money Gardener’s stock posts! :)

CC – I agree that risk has to be factored in as well. A lot of great returns are a function of good timing (ie luck).

8 Hunter Nuttall

This is why I’m such a big fan of index funds. How would someone feel to spend countless hours researching stocks, only to do worse than the index? Even if they get lucky and do better, they probably got paid less than minimum wage for their time.

9 WhereDoesAllMyMoneyGo.com

Great post! I was actually going to write a related post on the “actual cost” of management. Some researchers created a formula that basically measures the difference between a fund and it’s benchmark (the compositions of each) and then calculates the expenses solely based on the difference between the two.

In other words, if you own a Canadian Equity fund and it closely mirrors the index, but has a few overweights/underweights then the management is “active” for only the difference between the index and the fund.

The true cost of management for most funds is closer to 7-9% if you look at it this way!

10 telly

Some of us do our trading and researching at work while we’re getting paid though. ;) I guess one could argue that working harder could lead to promotions / etc. in the future, so missed wage opportunity.

Mike, I don’t worry TOO much about my current holdings as, like you said, they were purchased as long term holds, however, I actually appreciate the dips as it makes me remember why I choose to be an index investor. If my stock picks weren’t such obvious losers, I’d likely think I was a better stock picker than I am and would tend to move towards individual stocks…accidentally. ;)

Anyway, as far as I’m concerned, indexing is preferrable for reasons beyond just less analysis. DCAing works better for budgets and allows us to keep our assest allocation a bit tighter (stock pickers tend to have cash available for dips).

11 Mr. Cheap

telly: Apparently that’s why women make better investors, you look at your returns see the reality (in this case the impact of active vs. passive management). I think men tend to either just look at their successes (and get over-confident) or their failures (and get depressed).

12 Four Pillars

Hi Hunter, I agree – you have to beat the index by a significant amount to make active trading worthwhile.

WDAMMG – Interesting definition of expenses…I wonder how my LSIFs rate on that measurement! I think you should still that post.

Telly – yes, research done at work is ok!

Mike

13 Lise

WDAMMG – agree with Mike. Do write that post. I’m very weary of management costs of any kind, the more I learn from you folks, the happier I am. (My friends, on the other had, wish I’d stop reading FP blogs!)

I once read that if you sat tight on good stocks, you always came out ahead.

So, I got into a game with my bro-in-law, who is also self-directed and quite knowledgeable (he works in the biz.)

He freaked a number of times that I refused to sell. But we compare year after year, and after awhile, it became obvious that I was doing better than him. Not hugely, but better. And I saved all that time. (We only compare stocks we have in common. For all I know, he’s making zillions with his other invesments.)

If it’s a solid company, I stick with it. 80% of my portfolio is “risk proof” by my standards and I never touch it. (Ok, almost never.)

Buy ‘n hold, that’s me.

14 mariam

Hey Mike,

As you know, I’m “experimenting” with investments :)

I’m always torn between indexing or an active portfolio. So far, I’m splitting it 95% and 5%.

And then I go off the deep end and do some swing trading.

In no way do I believe that I can beat the index but I do think that there is “pocket” money to be had :)

15 Four Pillars

Lise, that sounds like a great strategy to me. With a bit of diversification you can hold ‘em, till you need ‘em.

Miriam – I’d say if your portfolio is 95% indexed then you are “allowed” to have some fun with the other 5%.

The thing with beating the index is that it’s not hard to do it for a short period of time (your odds are almost 50/50). The problem is doing for a long period of time.

16 plonkee

If it’s your retirement portfolio that you’re investing, I think that (regardless of your strategy) you should be comparing it to the relevant target retirement fund. I think that’s probably the best default investment for benchmarking purposes.

17 FourPillars

Plonkee – that’s a very good way to measure your performance but only if you can find a retirement fund that matches your asset allocation exactly.

Typically someone might create their own comparison index by combining appropriate equity/bond indexes that match their portfolio.

Mike

18 Praveen

The best of both worlds is to keep either diversified stock portfolio or ETFs, and then rebalance once a year if they fluctuate by 10% or more.

This is the system I follow and teach in my book.

This keeps you from wasting time actively trading, but it still lets you capture the bigger trends / swings.

19 MarkP

Let me preface my comment by saying I don’t know if it is possible to beat an index long term (10+ years) but if someone is able to beat the index by 2% annually, it is worth it. Compounding the extra return over a long period of time adds up quickly, it is the same argument to pick low MERs funds over high cost ones. The additional 2% drag on high MER funds cost hundreds of thousands over a lifetime.

20 Mike Holman

@MarkP – Good point!

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