Do You Really “Earn” Your Investment Income?

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.