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An Open Letter to Rachel Fox

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Dear Rachel,

I see from your Feb. 15, 2013 appearance on Breakout, with Jeff Macke, that you are an accomplished actress who has been trying your hand at day trading. You also have a website where you help "teach people about investing."

I admire your achievements and especially your ambition. Macke is correct. You are certainly not "an ordinary 16-year old." I hope you take this letter in the spirit in which it is intended. Your goal of making money by day trading is far more likely to fail than succeed. You have a fundamental misunderstanding of the capital markets. While your intentions are pure, by "educating" others in day trading and stock picking, you will likely do both them and yourself far more harm than good.

Stellar returns for one year does not make you a stock guru

To start, don't take too much comfort in your track record. I accept on faith that you earned a 30.4 percent gain in 2012, although I would be interested in know if your returns were net of transaction costs. Macke compares this gain to "the benchmark S&P 500", which earned only 13 percent. This comparison is probably very misleading. I suspect your trades were not limited to the 500 companies in leading industries in the U.S. economy. You likely took far more risk than this index, and may have also included international stocks in your trades. Incorrect benchmarking is a very common mistake. To accurately assess your performance, I would have to understand the amount of risk you took, and then compare that level of risk to a comparable benchmark with similar risk.

Stock Picking is a Loser's Game

I understand you learned about stock picking from your mom. I think it's great that she taught you about stocks and bonds, but your overall investment strategy is contrary to the teachings of hundreds of peer-reviewed academic articles and more than 84 years of long-term risk and return data.

Let's start with day trading. The SEC published an informative article on the perils of day trading. I suggest you read it carefully. It notes that day trading can be "highly risky" and that day traders should be prepared to suffer "severe financial losses." According to the SEC, many day traders "never graduate to profit-making status." One study found that 70 percent of the day trading accounts analyzed not only lost money "but will almost certainly lose everything they invest."

It's tempting for nearly all of us to believe we have the ability to pick outperforming stocks, but Wall Street is littered with the bodies of very well-trained stock pickers who thought they had a special skill and found they didn't. Merton Miller, Ph.D, a Nobel Laureate, observed that stock picking is a "game of chance operation" and that "people think they are doing something purposeful... but they're really not."

According to Standard & Poor's mid-year 2012 Scorecard, almost 90 percent of all actively managed domestic stock funds failed to equal the performance of their benchmark for the one-year period ending June 30, 2012. Many of these fund managers are superbly trained, with advanced degrees in finance and economics at top-notch business schools. Some have years of experience. They are supported by a cadre of skilled analysts, proprietary software and high-speed computers. Yet they had this dismal record of underperforming their benchmark index. Is it realistic to expect you are more skilled than these full-time professionals?

Think about it this way: I understand you get up at 6:30 a.m. to study the markets. What do you learn that is not already in the public domain and has been analyzed by millions of other investors all over the world? They have incorporated this information in the price of publicly traded stocks. As such, it's unlikely these stocks are mispriced. To be successful trader, you would have to know tomorrow's news, because that's what drives prices. Nothing in your "gut instinct," "technicals," and "stock charts" can tell you what tomorrow's news will be.

One final point: Why do you assume the party on the other side of the trade is dumber than you? When you are buying, someone is selling. That party believes the stock is overpriced. How confident are you they are wrong? Would it make a difference if the other party was a large institution like Goldman Sachs?

A Better Way

In my view, you are gambling, not investing, with your hard-earned acting income. Finance is taught at every major business school in this country. I am unaware of any that tout the merits of day trading or stock picking. If you really want to learn how to invest, here are some books you should read. They are all supported by reams of academic data. I left many good ones off the list, and limited my recommendations to ones that are not bogged down with a lot of technical information:

  • The Little Book of Common Sense Investing, by John C. Bogle
  • Think, Act, and Invest Like Warren Buffett, by Larry Swedroe
  • How A Second Grader Beats Wall Street, by Allan S. Roth
  • The Smartest Investment Book You'll Ever Read (my book)

A seminal book on investing is A Random Walk Down Wall Street, by Burton G. Malkiel. It's not an easy read, but you should buy it and use it as a valuable resource.

Fortunately, you have a lot of time to reverse course. I wish you continued success.

Dan Solin