Can I Actively Trade My Way Out Of This Economic Mess?
Be Wary Of Easy Answers To Hard Problems
Key Ideas
- Why it's a horrible idea to spend your retirement accounts early.
- The common belief most investors have about active trading… that's dangerously wrong!
- Know the truth behind the statistic before jumping into active trading.
A reader asks…
“…I'm an architect suffering under this dreadful economy like so many of us are, and I need to do something to help carry me through… What I'd like to do is use a portion of my IRA funds to educate myself further in the investment arena, pay back the loan, and use the remainder of the IRA to actively invest for income and growth. In other words, keep a portion of the earnings to supplement my income and reinvest the rest for growth. Does that sound like a reasonable idea?”
To paraphrase the question I'm really hearing two separate questions…
- Is it okay to spend (or borrow) retirement assets as an expedient way to accomplish an objective prior to retirement?
- Is it reasonable to take up active trading as a way to increase investment return to supplement current income and still grow my IRA?
My short answer to both these questions is “no” and “no,” and I'll explain why below…
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Is It Okay To Spend Retirement Assets?
The number of situations in which it's acceptable to withdraw money from your IRA accounts prior to retirement can be counted on one hand with fingers left over.
It's generally almost always a bad idea. You'll pay penalties, taxes, and do irreparable damage to the compound growth necessary to fund retirement.
The reason people raid their retirement fund for current spending is because it's easy. It's money they have access to which provides an expedient solution to a pressing problem.
Alternative solutions can nearly always be found, but they're also more difficult… IN THE SHORT RUN.
But in the long run, spending your retirement accounts is usually the worst solution and should be avoided.
In summary, you should always try to avoid spending retirement accounts until you actually retire. There's usually a better long-term solution, even if it's more difficult right now.
Active Trading…
Regarding the active trading question, my concern is there may be a false belief about what's possible with active trading.
While I support active trading as a risk management tool, there are a lot of hucksters making unrealistic claims of high returns to promote their active investing courses. Don't believe them.
Active trading isn't nearly as effective at increasing returns net of expenses as it is at lowering risk. It's very realistic to expect a better risk-adjusted return, but don't expect to knock the ball out of the park just because you take an active investment approach.
And BTW, you could do much worse than the passive approach if you make certain common mistakes. Improved returns only come to those with excellent skill.
If you're not sure whether to believe me or the hucksters marketing the courses, then I suggest studying the returns of hedge funds with special note on the percentage of funds that fail (a database without survivorship bias).
Hedge funds attract the best and brightest of active trading; yet, the results aren't impressive over the long term.
It's exceedingly rare to earn better than a 1:1 risk to reward ratio over the long term (net of expenses and taxes).
Sure, there are stars every year with amazing investment results, but over the long-term, you'll find very few who produce better than a 1:1 risk/reward ratio.
What that means is that depending on the size of your IRA and your particular abilities in active trading, it may not be realistic to supplement current income and still build retirement security from the same account.
There may not be enough to go around net of inflation and growth requirements (not to mention the penalties and taxes associated with premature distributions).
I'm sorry, but it isn't as easy as all the promoters make it sound. Active trading is great for risk management, but don't expect outsized returns over the long-term.
In Summary…
My suggestion is if you want to take up active trading that's fine, but recognize it has a learning curve like any other profession.
Set realistic time and training expectations. Keep your day job because it's not a slam dunk (despite what the huckster promoters may claim).
Don't spend your IRA money – figure out another way to accomplish the objective.
If you're truly committed to this path (which you will need to be in order to succeed), then you'll find another solution.
In other words, there's nothing inherently wrong with your overall objective – to become an active trader and to figure out solutions to your economic difficulties. I would just be careful how you implement these solutions to protect yourself from the downside risk.
My two cents worth…
Let me know your two cents worth in the comments below. What do you think of his question and what do you think of my advice?
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My advise is to not use your retirement account for anything but retirement. It’s too easy to blow through money even if it’s for education. I should know because I work in the education system. And second, don’t go into active trading because that is like gambling.
@Dave – Thank you for contributing to the discussion. I deleted the link in your comment even though I rarely (almost never) edit anyone’s comment because I consider it inappropriate to include commercial links in comments.
Regarding your position on active trading, I politely disagree. I know that what you are saying is the conventional wisdom and is supported throughout much of the investment community; however, it is just flat-out wrong. I have personally practiced “active trading” as a risk management discipline throughout my career and it has always worked. It is not valid for speculative gains as it is commonly used, but it does work to reduce risk and improve risk adjusted returns.
For additional insights on investing vs. gambling I highly recommend this article.
I have two things to say about active trading in terms of philosophy and practicality
Practicality: I spent about a year, $2000 of my own money and 2 blown trading accounts to find out that day trading is an extremely tough way to make money. While I was trying to learn how to trade I found that it was very stressful, didn’t really have defined rules and you couldn’t really make money at it unless you had alot of money already and/or used plenty of leverage. To be honest with you I feel pretty stupid for even trying. Given the same amount of time and money I probably could have gotten more by getting a job and/or buying investment property that provides a steady stream of income that will rise with inflation. Not to mention that managing single family houses is way less difficult and stressful than learning to trade.
Philosophy: As Todd has already pointed out even the best traders don’t do extremely well over the long run because day trading has too many expenses and risks to make truly outsized gains. Warren buffett smoked all those guys in the long run with less risk and stress than the traders. As buffett puts it, “wall street is built on the short term game and there really isn’t any way to beat these guys at that because its thier life. The only way to beat them is to play the long game”(I’m paraphrasing here)
If I were in the position discussed and really wanted to retire I’d probably just read up on rental property and get into that. You can leverage easier, it makes more money, has less risk and is more reliable as a source of cash flow for bills.
@Dustin – Thanks for sharing your input. You make some important points.
I just want to add some distinctions at this point in the conversation. Active investing can operate on a variety of time frames – both short and long term – and still be active investing. Day trading would be an extreme short-term practice and a 200 day moving average or a valuation strategy might be a long-term time frame in the active management world. It is a common mistake to confuse the term “active investing” with short term timing.
I will go on record here as not being in favor of short-term trading strategies for anyone who isn’t operating on the exchange floors. My experience is that even the guys who can get it right for a period of time have a remarkable tendency to blow up eventually. The result is an unfavorable risk/reward ratio.
Just wanted to make sure that was clear…
Todd, I read the “gambling vs. investing” article. How does one gather the data and go about determining a mathematical expecation?
@ John – Thanks for joining the conversation…
Investing as a science (as opposed to gambling or guessing) using mathematical expectation requires research – either your research or someone elses. There is a ton of academic research and quite a few good articles if you don’t want to do any yourself. However, I do recommend committing some energy to testing a model before putting money at risk because it will increase your depth of understanding and commitment.
In short, the implication of mathematical expectation is that your strategy stands on the foundation of solid research that provides the data proving the positive expectation. It is a scientific approach to investing that takes away the guessing, emotions (sort of), and gambling of most investment practices.
I understand the temptation of active trading … but not with your retirement savings because I think it’s difficult to beat the market consistently and depending on your age maybe there’s no chance to recover from that loss.
Nowadays I am studying Technical Analysis because although I believe in valuation and Fundamental Analysis, I find more difficult to gather the data of the companies, to know how to read them and what is worse to believe in them.
Todd, have you any suggestion to learn and use both of these Analysis? (books, semminars,…)
Thanks
@Pedro – Funny you should ask… On my to-do list this month is to get my “Recommended Reading” lists up under the “Free Stuff” menu category. I will announce it in the blog updates as soon as it is available.
Thanks for your input!
I’m new to this site and really enjoying the material so far. I’m looking forward to digging in more.
I wanted to suggest that anyone interested in active trading first practice with a virtual account, which I am doing now. I’m forcing myself to limit how much real money I actively trade with until I can find the strategies that fit me best and that I can be routinely successful with. Trading with fake money is extremely eye-opening and educational. One of the most important lessons so far has been seeing how much commissions eat into profits. I’m also learning how to limit losses and protect gains, and how to hedge long stock positions. Good stuff!
@Tim – Thanks for stopping by and sharing your insights. I look forward to hearing more from you in the future.