There is no denying that “free” is going to change the way we all invest in the future. Commission-free trading, virtually free ETFs and low-cost portfolio management services are all pushing towards a frictionless investing world. In many ways that is a huge boon to investors. Earlier this year I wrote:
The world is always changing and for investors it is changing even more rapidly. It is worth taking a moment to think about how these trends will affect you. For most individuals who really don’t enjoy the process of investing it will be a boon. The challenge as always in investing is to minimize the risk that our analog brains don’t short-circuit us along the way.
Like all advances, the benefit of free trading can be abused as well. We are all flawed creatures who are going to be increasingly at-risk of using these advances for ill, not good. Perhaps investors (and traders) would be well-served by putting some constraints on how it is they go about the business of managing their portfolios. Warren Buffett is famous for telling investors to to think about having a 20-punch ticket when it comes to their investing.
You’d get very rich if you thought of yourself as having a card with only twenty punches in a lifetime, and every financial decision used up one punch. You’d resist the temptation to dabble. You’d make more good decisions and you’d make more big decisions. —Warren Buffett, quoted in The Snowball by Alice Schroeder (via Huffington Post)
This imaginary restriction should only serve to sharpen your thinking before investing. One thing that having the done the work ahead of time is that it provides you with some measure of confidence going forward. Bill Mann from the Motley Fool archives on Buffett’s idea:
There’s no limitation for how many times you can trade, but think about the care that you would put into each decision if there were. A wasted decision in this case would be nearly as hobbling as a loss in capital, which would mean that each decision would be taken with the greatest of care, after you’ve taken the time to tear the company limb from limb to understand what you’re getting into.
Constraints, at their best, can help us focus on what is important. The same thing applies to traders as well as investors. Brett Steenbarger at TraderFeed suggests that limits force us to become more patient and creative. He writes:
Another constraint exercise for traders that I have found useful is to approach the market day by assuming that you can only place three trades all day long. With only three bullets to fire, you have to adapt to the constraint by exercising unusual patience and selectivity, focusing on best setups at very good price levels. This selectivity can be cultivated as a habit, as the constraints prevent traders from overtrading.
Overtrading, even in an era of virtually free trades, is still a problem. Too many trades, done with too little discipline, can only serve to erode our ability to successfully manage our emotions and portfolio. Gatis Roze at StockCharts notes the parallels between professional athletes who have a limited number of opportunities in their careers and traders. Luckily traders do have the ability to extend their careers and shepherd their energies over time. Roze writes:
Unlike pro athletes, we individual investors do not necessarily have to perform on a schedule and under any contract…We don’t have to swing at every pitch. We don’t have to accept a specific ball-carrying assignment. We can wait for exactly the perfect pitch thrown at our personal sweet spot or accept the ball carry only if there’s a 20-yard open gap in the opposing team’s defense.
Free trades will certainly tempt many to try marginal trades that they would not have considered previously. The big risk isn’t that they will lose on these trades, although that is a real issue. The big risk is that they spend their time and emotional capital on these trivial trades and miss more promising “perfect pitches” that have real opportunities for gains. Constraints on your trading (and investing) aren’t necessarily fun, but they are a useful exercise. Then again nobody said all of this was supposed to be fun anyway.