Trading vs. 50th Percentile Performance

The appeal of trading to many is obvious. 

The financial markets, with their constant fluctuations and potential for gains, draw in many individuals eager to test their skills and see how much they can make. 

But it’s also important to remember that, for as complex as markets are, and as tough as they can be to trade, 50th percentile performance is always given to you.

We’ll explore the nuances of this more in this article.

Key Takeaways – Trading vs. 50th Percentile Performance

• 50th Percentile is a Benchmark, Not a Target
  • Simply investing in broad market index funds will give you roughly the average market return (a type of 50th percentile). 
  • “Beta” is free.
  • For active traders, achieving this is above average due to trading costs and the difficulty of consistently beating the market. 
  • Don’t underestimate the value of this “average” return.
    
• Active Trading is a Negative-Sum Game (Mostly)
  • After factoring in transaction costs (brokerage fees, commissions, taxes), active trading becomes a negative-sum game for most. 
  • While a few outperform, the majority underperform the market.
    
• Consider Your Edge and Goals
  • Market participants with specific financial goals require active management strategies that offer more precise control over both return and risk, unlike passive indexing which can’t address such nuanced objectives.
    • These “absolute return” strategies prioritize achieving specific targets regardless of market performance or performance relative to others.
  • Active trading may also be worthwhile if you have specific expertise in a sector or have unique financial goals requiring tailored strategies. 
  • Nonetheless, without a demonstrable edge and a sound risk management plan, pursuing market-beating returns through active trading is unlikely to succeed long term.

Understanding the 50th Percentile

The 50th percentile represents the average market return.

For active traders, achieving market-level returns is actually above-average performance, as most active traders tend to underperform the market.

Alpha – the return above market performance – is essentially a zero-sum game, and when transaction costs are factored in, it becomes a negative-sum game.

In something where a small fraction of traders achieve market-beating returns while the majority incur losses, an active trader matching market returns would rank higher than the 50th percentile.

Nevertheless, for simplicity, let’s approximate it to the 50th percentile.

This means that if you simply invest in a broad market index fund, such as one that tracks the S&P 500, you’re basicially guaranteeing yourself the average return of the market.

You’re right in the middle, with half the money invested performing better and half performing worse.

Efficient Market Hypothesis

This concept is intrinsically linked to the efficient market hypothesis, which posits that all available information is already reflected in the current market prices. 

According to the EMH, it’s impossible to consistently “beat the market” without taking on additional risk or having access to insider information.

The EMH may not be entirely accurate. In fact, if you’re reading this, you probably don’t believe in it. 

Markets can exhibit inefficiencies. But the assumption provides a solid foundation for those without a competitive edge by emphasizing the difficulty of consistently outperforming the market. 

For most, assuming markets are efficient is a prudent starting point until they can identify and exploit genuine opportunities.

The Allure and Challenges of Active Trading

Active trading, on the other hand, involves the frequent buying and selling of securities in an attempt to outperform the market.

It’s a dynamic and potentially rewarding endeavor that attracts those who believe they can identify mispriced assets or predict market movements.

Active trading nonetheless comes with its own set of challenges.

First, it requires a significant investment of time and effort.

Traders need to monitor the market, analyze data, and make quick decisions. This can be very demanding and may not be suitable for everyone.

Second, active trading often incurs higher transaction costs. Every trade you make comes with brokerage fees, commissions, and taxes, which can eat into your profits. The more frequently you trade, the more these costs accumulate.

Moreover, active trading can be emotionally taxing. The constant ups and downs of the market can lead to stress, anxiety, and impulsive decisions.

This can be detrimental to your overall trading performance and well-being.

One of the biggest mistakes is buying what’s recently gone up and selling what’s recently gone down, believing prices are reinforcing their quality, rather than seeing higher prices as more expensive and lower prices as cheaper.

Imagine if we acted like that with consumption items, buying when prices rise and ignoring all the sales. We’d simply have less money. Markets are a lot like that as well.

Importance of Careful Consideration

Before actively trading, it’s important to ask yourself some key questions:

• Are you truly passionate about trading? Do you enjoy spending hours analyzing markets, reading financial news, and staying up-to-date on market trends?
• Do you have the time and resources to dedicate to active trading? It’s not a passive endeavor and requires a lot of consistent effort and attention. It’s an opportunity cost.
• Are you comfortable with the risks involved? Active trading can lead to large losses, especially for inexperienced traders.  
• Do you have a well-defined trading strategy? Without a clear plan, you’re essentially gambling, not trading or investing. Trading is different from gambling because of the analytic element.
• Are you emotionally resilient? Can you handle the inevitable losses and setbacks without making impulsive decisions?

If you answered “no” to any of these questions, you might want to reconsider your decision to actively trade. 

It’s perfectly fine to stick with passive investing and enjoy the 50th percentile returns.

Achieving average market performance reinforced by your savings rate can lead to great results over time.

When Active Trading Might Be Worth It

There are certain scenarios where active trading might be a worthwhile pursuit:

Specific Goals

If you have specific financial goals, you’ll need different strategies to help you get there.

For example, some people want better return-to-risk ratios than standard 100% stocks or 60/40 portfolios.

Some want more risk. Some want less risk.

This should nonetheless be approached with caution and a well-defined strategy.

Everything flows from your personal goals.

Some have specific, nuanced financial goals that passive indexing simply cannot address. 

For example, an investor might aim for a return of CPI + 450bps annually with a 10% drawdown cap. (This might be an actual type of goal from a sovereign wealth fund or analogous investor.)

In other words, CPI (Consumer Price Index, a measure of inflation) plus 450 basis points (4.5%) annually, while simultaneously limiting potential drawdowns (losses) to a maximum of 10%. 

This is a very specific objective:

• CPI + 450 bps – This targets a real return (return above inflation) of 4.5%. This is a more aggressive target than simply matching market returns, as it tries to outpace inflation by a specific return.
• Drawdown Cap of 10% – This sets a hard limit on potential losses in any given period. This is a risk management constraint that passive index funds, which can experience larger declines during market downturns, don’t offer.

Such a goal requires active management strategies that attempt to generate higher returns than the market while also actively managing risk to stay within the drawdown limit. 

Passive indexing, by its nature, can’t offer this level of precise control over both return and risk.

They also don’t care about market returns, just that they’re achieving their objective.

This is what’s considered an “absolute return” strategy.

In a given year, the S&P 500 might be up 30% or down -20%. Over the long run, the return is pretty decent, but it can be all over the place year to year. Whether they’re beating that doesn’t matter to those with specific objectives who just want to achieve their goals.

Therefore, for market participants with these types of highly specific objectives, pursuing active strategies becomes a necessity, not just a choice.

Expertise and Edge

If you have deep knowledge or expertise in a particular sector or market, you might be able to identify opportunities that others miss.

This could give you an edge in active trading.

We have different articles on what it means to have an edge – both in terms of knowledge and expertise and in terms of the concept of statistical edge.

Time Commitment

If you have ample time and are willing to dedicate yourself to learning trading, you might be able to achieve market-beating gains through whatever form it takes.

Risk Tolerance

If you have a high risk tolerance and are comfortable with the downswings it produces, active trading might be suitable for you.

It’s nonetheless important to have a sound risk management strategy in place.

Conclusion

The decision to actively trade or stick with what’s essentially 50th percentile performance is a personal one. 

There’s no right or wrong answer, and the best approach depends on your individual circumstances, goals, and risk tolerance.

If you’re considering active trading, it’s important to be realistic about your expectations and understand the challenges involved. 

It’s not a get-rich-quick scheme and requires significant effort, discipline, and emotional resilience.  

Average market return is a respectable achievement in itself. Don’t feel pressured to actively trade if it’s not aligned with your personality, goals, or risk appetite.

Ultimately, choose a strategy that best suits your needs and aspirations. Whether you decide to actively trade or passively invest, remember that either way the path to financial success is a marathon, not a sprint.