There are two ways you can make money in the stock market…
- Closing your investment at a better price (that’s generally selling at a higher price)
- Collecting dividends or other distributions
If you’re trading in the short-term, you’re not receiving dividends or other direct capital returns. Instead, your only hope of a positive return is selling your stake to other investors for more. And this is where greater fool theory can come into play.
Short-Term Trading with Greater Fool Theory
Greater fool theory states that the underlying value doesn’t matter. And when you buy anything without looking at the price relative to the value, you’re a fool. Of course, on occasion you can get lucky. But here’s the kicker: you must often hope there’s a greater fool to buy from you at a higher price later on.
Greater fool theory helps to explain how asset bubbles can grow, like the tulip bubble in the 1600s or the more recent housing bubble.
Now, not all short-term trading fits into greater fool theory, but the idea still lends a hand. The big takeaway is that in the short-term, there’s no direct underlying return of value. There are only hopes of a better exit price.
In the short-term, the only transaction is between the buyer and seller. There’s always someone else on the other end of a trade. Sometimes people forget that. And money changes hands based on the agreed upon price. This is why short-term trading is a zero-sum game. Although, it’s even a little worse than that…
Worse Than a Zero Sum Game
Throughout most of recent history, brokers charged an arm and a leg for trading. And those fees make short-term trading less than a zero-sum game. When you enter a trade, you’re already down on the position thanks to the trading cost. Back in the 1980s, brokers would regularly charge $50 to make a simple stock trade.
Now, technology has helped level the playing field. Many brokers offer free trading today. Still, there are less obvious costs involved when buying and selling stocks. Also, there are still contract fees for derivatives like options, etc.
Based on an asset’s liquidity, you might pay a bigger piece of a wider bid-ask spread. This is one of many overlooked trading costs. So, I hope it’s clear that short-term trading is still slightly worse than a zero-sum game.
Over the long-run, real value is added and eventually passed on to investors. Some research points to dividends being the major source of stock market returns over the long run. Depending on the timeframe – a few decades to a century – I’ve seen dividends contribute 50-90% of total returns. There’s plenty of back-and-forth online about how much dividends actually contribute. But I’m not going to split hairs. The big takeaway is that they’re important.
That’s why I’m a long-term dividend investor. Also, uncle Sam taxes long-term capital gains at a lower rate. These reasons are why I focus on finding undervalued dividend paying companies – or companies I think will eventually start paying dividends, like my recent investment in Facebook. And when I buy, I hope to hold forever, just like Warren Buffett.
With that said, I still admit some people can profit from short-term trading. Some strategies have proven to be successful. Although, based on my decade plus of research and direct investing experience, as well as passing the CFA exams, I plan on staying away from short-term trading. That’s unless I’m hedging certain positions or making tax-motivated moves.
Do you have any thoughts on short-term vs. long-term trading? Or really any unique insight to share? I’d love to hear from you. Simply drop a comment below.