Whenever expected pick-up exceeds frictional costs, it makes sense to trade out of one asset and into another that promises the higher return.

If markets are efficient, with perfect and instantaneous information flow among all participants, no pick-up in expected return should be available from switching out of one asset and into another, instead, frictional costs will only drag down returns. On the other hand, if it is possible to use available information to one’s advantage to outsmart others, then trading can be a highly profitable business.

Prominent Winners and Losers

A glance at popular lists of the rich and famous shows that at least a few people have been amazingly successful trading the markets. Here are some well-known traders on the Forbes list of the 400 wealthiest Americans.

George Soros (age 77) is #33, with a net worth of $8.8 billion. Bachelor’s, London School of Economics. Founded Quantum Fund with Jim Rogers. With Stanley Druckenmiller, broke British pound in 1992, and made a $1 billion profit. In 1996, he lost hundreds of millions with ill-timed investments in the former Soviet Union.

Steven Cohen (age 51) is #47, with a net worth of $6.8 billion. Bachelor’s, Wharton, U. Penn. He founded hedge fund SAC Capital 1992 with $25 million in assets. Today he manages $14 billion. Charges 3% of assets, 35% of profits, and has returned an average of 34% net of fees each year since 1992.

James Simons (age 69) is 57th, with a net worth of $5.5 billion. Math Ph.D. UC Berkeley. Founded Renaissance Technologies 1982. His quantitative hedge fund uses complex computer models to analyze, and trade securities. The fees are as high as 5% of assets, and 44% of profits. A $2.5 million investment in his funds in 1990 would be worth $1 billion today (for a 42% annualized return ). He hires Ph.D.s over M.B.A.s. So far, his $25 billion institutional fund RIEF is performing below expectations.

Stanley Druckenmiller (age 54) is #91, with a net worth of $3.5 billion. Bachelor’s, Bowdoin College. He orchestrated a billion-dollar raid on the British pound in 1992 with a timely short position. He is believed to have helped generate a string of 30% returns for Soros’ Quantum Fund. Duquesne Capital Management, and runs No Margin Fund.

Bruce Kovner (age 62): #91, with a net worth of $3.5 billion. Bachelor’s, Harvard. He started trading soybeans where he turned $3,000 that he borrowed on his credit card into $45,000. Then, he forgot to hedge, and lost half of the profits. In 1983 he founded Caxton Associates. The Caxton Global Investments hedge fund has returned 25% annually net of fees. Assets: $15 billion.

Paul Tudor Jones II (age 53) is #105, with a net worth of $3.3 billion. Economics, Bachelor’s, Univ. of Virginia. His early success was trading cotton on Wall Street. In 980 he founded the Tudor Investment Corp. hedge fund. he predicted the 1987 stock market crash, and returned 125% net of fees that year. Assets are now $20 billion. Estimated average annual returns are 24%. which is down this year amid summer’s violent market turmoil.

Kenneth Griffin (age 38) is #117, with a net worth of $3.0 billion. Bachelor’s, Harvard. He started investing as an undergrad, managing $1 million of family, and friends money by his senior year. He founded the Citadel Investment Group 1990 with Frank Meyer’s money. His hedge funds said to have averaged 20% net of fees annually. The assets under management exceed $16 billion.

David Shaw (age 56) is #165, with a net worth of $2.5 billion. Ph.D. Stanford. The investment geek uses complex algorithms to capitalize on tiny anomalies in the stock market. He is a former professor of computer science at Columbia U. and launched the D.E. Shaw & Co. hedge fund. Its assets have swelled from $28 million to $34 billion in 20 years (or 43% annual compounded asset accumulation ).

David Tepper (age 49) is #239, with a net worth of $2.0 billion. M.B.A. Carnegie Mellon. He ran the junk bond desk at Goldman Sachs, and in 1992 started the Appaloosa Management hedge fund. The fund up 150% in 2003, and is believed to have averaged 30% net return of fees since inception. He manages $7 billion.

Louis Bacon (age 51) is #286, with a net worth of $1.7 billion. Literature, Bachelor’s, Middlebury College. He founded Moore Capital in 1989, and returned 86% in its first year on a savvy bet that the Gulf War would drive up oil prices. Assets under management: $13 billion. Last year the fund returned 16.7% after fees (25% of profits, 3% of assets).

Daniel Och (age 46) is #317, with a net worth of $1.5 billion. Bachelor’s, Wharton, Univ. of Penn. In 1982 he took job in arbitrage at Goldman Sachs, and worked with both Eddie Lampert, and billionaire Richard Perry. He left to found the Och-Ziff hedge fund with a $100 million initial investment from the Ziff brothers. It has had consistent returns of 16.5% a year after fees. and manages $29.1 billion.

Israel Englander (age 59) is #317, with a net worth of $1.5 billion. Bachelor’s, NYU. In the 1980s, he founded the investment outfit called Jamie Securities, but the firm collapsed. He then created Millennium Partners in 1990. The fund is said to have returned 17% net of fees. It has $11.5 billion worth of assets under its management. The employees created 100 legal shell companies in order to market time mutual funds.

The constant 15% to 40% or higher annual returns that these traders show is evidence that it is possible to realize consistent profits trading the market.

But before we become too carried away with these success stories, we should also keep in mind that there have been many equally prominent blow-ups of risk-taking traders, including: Victor Niederhoffer. one of Soros’s former colleagues, whose funds failed twice — once in 1997, and again this year; John Meriwether ‘s Long-Term Capital Management, the multi-billion dollar hedge fund run by ex-Salmon traders, and even a couple Nobel prize winners in economics, which collapsed in 1997; and Amaranth Advisors, which spectacularly lost $6 billion in one week on natural gas futures in September 2006. This year’s subprime crisis is another example of how businesses, investments and trading strategies that have been profitable for many years can suddenly turn sour. It is also important to think about all of the unlucky traders who lose money so quickly that we never even get a chance to hear about them!

Base Strategy: Buy-and-Hold

The only way to know whether you, yourself have the ability become a successful trader is to commit both significant time and capital to test the waters. Unfortunately, most people have neither the time, nor capital to spend finding out whether or not they will actually succeed. Also, for those who seriously begin trading but fail, the costs can be very high, both financailly and emotionally.

In my opinion, instead of jumping off, and haphazardly trying your luck at trading, it makes sense, at least initially, to pursue a buy-and-hold strategy to exploit certain advantages it offers:

Long-Term Returns Favor Equities: The nature of capitalism as we know it in the U.S. and in most parts of the world is that laws and regulations are skewed to promote economic growth, corporate profits, and wealth generation for stockholders. In this environment, risk-taking buy-and-hold equity holders more often than not end up with higher returns than bondholders and cash-rich non-risk-takers. Therefore, it makes sense to allocate as much of your portfolio as you can to equities, reserving for cash and bonds only what you need for emergency living expenses (e.g. six months’ income in case you lose your job) or predictable future expenses (e.g. a college fund for children). While it is very difficult to predict whether equities will outperform bonds and cash in any given year, over periods of 10 or 20 years or longer, equities have generally outperformed.

Cost Efficiency: Compared to trading, buy-and-hold investing controls costs by keeping broker’s commissions, and other frictional costs to a minimum. Though not as evident as a trading commission, the bid-offer spread is a cost that can often be larger than commissions. To give an extreme example, a micro-cap penny stock with a $0.06-$0.08 bid-offer (you can buy at $0.08 and sell at $0.06 in an unchanged market), actually has round-trip execution costs of an enormous 25% of one’s initial investment! At the other end of the spectrum are exchange-traded funds (ETFs), the most liquid of which is the S&P Depositary Receipts (AMEX: SPY ) with round-trip bid-offer costs of just 0.007% (or less than 1 b.p.). More typically, moderately liquid mid-cap individual stocks have bid-offer spreads of about 0.50% (50 b.p.).

Tax Efficiency: Keeping portfolio turnover to a minimum through buy-and-hold investing is also more efficient from a tax point of view. First of all, the long-term capital gains tax rate of 15% that applies to positions held for more than a year is substantially lower than the ordinary income tax rate running as high as 28% that applies to short-term capital gains on positions held for a year or less. For certain types of trading accounts, the IRS offers a favorable 60%/40% split between long-term and short-term capital gains tax treatment, which produces an effective tax rate of 20.2% (of course, higher than the 15% pure long-term gains rate). Also, since taxes on gains are due only when securities are eventually sold, capital gains tax can be deferred indefinitely into the future through extending buy-and-hold positions without selling for many years.

While it may seem simplistic, a buy-and-hold approach to investing, characterized by continuously holding a very high percentage of equities with only very infrequent though carefully considered buy-sell decisions, can, in my opinion, give small retail investors a slight edge over other investors and traders based on the efficiencies cited above.

Numerical Comparison

To gauge the impact of frictional costs on returns, let’s compare two portfolios over a 10-year period in a market that returns 10% annually:

Buy-and-Hold: Assume no turnover. At 10% annual appreciationn, $100 grows to $259 after 10 years. After payment of 15% long-term capital gains tax on the $159 gain at the end of year 10, the net portfolio value becomes $235, for an annualized after-tax return of 8.94%.

Trading: Assume 200% annual turnover, or the equivalent of two round-trip trades per year at a cost of 0.50% per round-trip. Trading costs as stated and annual taxes of 28% on short-term gains reduce the 10% annual market appreciation to (10% — 2 x 0.50%) x (1 — 0.28), or 6.48%. At this after-tax growth rate, an original $100 investment becomes $187 after 10 years.

Assuming that trading produces no pick-up in return, the frictional trading costs and additional tax lead to an inferior after-tax annual return 246 b.p. lower (8.94% vs. 6.48%) than the return available through buy-and-hold investing. On a pre-cost, pre-tax breakeven basis, the trading strategy will need to outperform the buy-and-hold alternative by a full 342 b.p. annually in order for trading to beat the buy-and-hold alternative.

As a rough rule of thumb, then, you should engage in trading only if you honestly believe that your buy-sell decisions give you at least a three or four percentage point advantage annually (and more if your turnover exceeds 200% per year), above the buy-and-hold alternative.

Self-Assessment: What’s My Trading Edge?

Expressed another way, the buy-and-hold versus trading decision really boils down to having an edge large enough to overcome the costs of trading. What in particular about you, your personality, your abilities, and your current situation gives you a competitive advantage over others in the market? Based on the information you can easily get your hands on, digest and analyze, do you have an edge over professionals who devote themselves full-time and make careers out of trading the market?

While a genius-level of business and financial acumen may not be strictly necessary for wealth-building, I would contend that your odds of becoming a successful investor or trader will be greatly enhanced if you know what your edge is. If you plan to trade ETFs or large-cap stocks over a short-term time horizon, keep in mind that you’ll be competing with Wall Street traders and hedge funds who usually have access to more up-to-the-minute newswires, customer flow information, and analytical tools than you do. Your odds of success may be slightly better in small-cap and penny stocks, asset classes that more sophisticated investors often avoid due to limited liquidity, and trade size (Tim Sykes. whose claim to fame is trading his way from $12,415 to $1.65 million in just four years, day-trades small-cap stocks, and is attempting to teach us all how it can be done again).

Over the years I have looked at many fundamental, technical and sentiment-based possibilities for constructing a system for beating the market, always searching for a methodology to ensure at least a 70% winning trade percentage. From one (perhaps too naive and hopeful?) point of view, given how readily availability price, volume, earnings and other quantifiable time series are, it seems that trading ought to be a science amenable to analysis and predictability. Unfortunately, from what I have seen so far, analytical trading rules do not appear to produce excess returns in any consistent and reliable way. Also, to date, I have yet to meet anyone who has a trading system that runs without human intervention, and that produces consistent excess returns. From what I can tell, trading is more like a game involving both luck and skill than a predictive science.

To Trade or Not To Trade?

Whether to engage in buy-and-hold investing or to pursue a short- or middle-term trading strategy, then, really depends on your own abilities and risk preferences. For the vast majority of people, I suspect that a buy-and-hold strategy will bear larger, and more fruit than an active trading strategy. In my own case, I currently follow a buy-and-hold approach, targeting no more than a 10% annual turnover to keep trading costs and taxes at a minimum.

Concurrently, I continue my search for a Holy Grail of sorts that is capable of producing winning trades at least 70% of the time (which I view as equivalent to a low-C grade, i.e. barely passing). The day I convince myself that I have a working system that meets this 70% threshold, I will begin to trade, putting real money at risk.

By the way, to anyone reading this: If you or someone you know has a trading system that produces consistent and reliable above-market returns, and don’t mind sharing a little information about it, please leave a comment. We would all love to hear about it.

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