An important distinction to understand before you can build wealth is the difference between “trading” and “investing”.
Trading is the churn of buying and selling to make a profit on the difference. It evokes images of these day traders with 14 screens in front of them full of charts making strategic decisions about when to jump in and out of specific stocks. It seems like a great way to make some serious cash if you can just figure out the system of when to get in and out. But here’s the dirty little secret about trading. If you add up ALL THE GAINS made by ALL OF THE TRADERS in ALL OF THE WORLD, relative to the gains of the market, they add up to exactly zero.
“ZERO?!” You’re probably shouting to yourself as you read this while you’re sitting on the toilet. Yep! It all comes down to the concept of “alpha” and “beta”. When you look at the stock market you can break down the gains of any trader into those two parts. Beta is the gain of the ENTIRE market. For example if the value of ALL the stocks increase by 10% in a given year, we’re all beneficiaries of that rising tide. Alpha is the amount by which a trader BEATS the market. For example, if a trader earns 12% in a given year, 10% is the beta we all got, and 2% is the alpha or outperformance that the trader got.
Mathematically, it turns out, all of the alpha in the entire market adds up to zero. Zero percent. Zero dollars and zero cents. Because on every trade, someone has to be on the other side. If one trader made 12%, another, by definition, had to make 8% since the average is 10%. Being a trader is wasting your time fighting over $0.
So what’s an investor? It’s ignoring the alpha and focusing on the beta. Buying low. Buying high. Buying and holding. Acquiring more shares over time to let the beta and compound growth make you rich. Buy low, sell high is nonsense trading advice. Buy low, buy high is how you get rich.
As always, reminding you to build wealth by following the two PFC rules: 1.) Live below your means and 2.) Invest early and often.
-Jeremy
