- Day trading, the activity of buying and selling
the same financial asset on the same day.
Sounds like one of the smartest approaches
to investing in stocks.
Why bother holding onto an index fund
when you can make daily profits.
And to make day trading sound even better,
there are lots of people on the internet
nice enough to teach you how to trade
and make huge, easy profits, just like they do
for a fee of course.
I'm Ben Felix Portfolio Manager at PWL Capital.
In this episode of Common Sense Investing.
I'm going to tell you what day trading can
and can't do for you.
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The first and most important thing to understand
about day trading is what the data say
about its effectiveness as a strategy.
There are a few data sets that researchers
have been able to get their hands on
to answer this question.
These data sets are unbiased samples of all transactions
for thousands of brokerage accounts.
The researchers define day traders in the data based
on the frequency of their transactions.
And then they analyze their performance,
a 2000 paper in the Journal of Finance
titled "Trading is hazardous to your wealth."
The common stock investment performance
of individual investors,
examined a data set of 66,465 households
with accounts at a large US discount broker
between 1991 and 1996.
They set out to test two competing theories
of individual trading activity.
One theory is that investors will trade
when the marginal benefit of doing so
exceeds the marginal cost.
The other theory is that investors are over confident
and will trade to their own detriment.
Based on their findings the authors conclude
that individual investors are overconfident,
based on the empirical evidence that the average household
earns a return close to the market before costs
but trails the market by about 1.1% annually after costs.
In other words, they trade to their own detriment.
They also found that the average household over this period
tilted its portfolio toward riskier small cap value stocks.
Accounting for these additional risk exposures
using the Fama-French three-factor model.
The average household trailed a risk appropriate benchmark
by 3.7% annually.
The average household turned over
about 75% of its portfolio holdings annually.
And the associated transaction costs
explained their poor performance.
The 20% of households in the sample
that traded the most often,
turning their holdings over more than twice annually
earn net returns that trail the market by 5.5% annually
and trailer risk appropriate benchmark by 10.3% annually.
These findings have theoretical significance.
In an efficient market an informational edge should be rare
and active management strategies like day trading
or investing in actively managed mutual funds,
should underperform passive strategies like index funds.
The author suggests that they're finding support
the theory from behavioral finance
that overconfident investors
overestimate the value of the information that they have
causing them to underperform by trading too frequently.
In a 2009 paper in The Review of Financial Studies titled
"Just how much to individual investors lose by trading."
The authors got their hands on a complete trading history
of all investors in Taiwan,
the world's 12th largest stock market
from 1995 through 2019.
They found that individuals who engage
in day trading reduced the aggregate portfolio return
for all individual investors by 3.8% per year.
These losses were attributed to trading losses,
commissions, transaction taxes, and market timing losses.
Stayed in different terms over this period.
Taiwanese individual investors in aggregate
lost about 2.2% of Taiwan's GDP to trading per year.
These researchers had the full data set
for all market participants in Taiwan.
So they were also able to observe that while
individuals encouraged trading and market timing losses
institutions gained from the same.
This speaks to the question
that individual investors should always ask themselves
before placing a trade,
"Who is on the other side?"
Do I know more than whoever I'm selling to or buying from,
these data intuitively suggest
that individuals are less informed
than institutions when they place trades.
The authors dug deeper into this issue
finding that nearly all of the losses incurred
by individuals stemmed from aggressive trades,
which they defined as by limit orders with high prices
and sell limit orders with low prices.
In other words when individual investors
were willing to buy higher above the market price
or sell lower below the market price.
In order to execute a trade,
they were willing to trade with urgency.
is when they tended to lose.
Institutions on the other hand made most
of their short-term trading profits from passive trades
where they were not demanding urgency
and were instead providing liquidity
to the individual investors.
As the authors of this study explain,
the institutional profits associated with passive trades
are realized quickly
as institutions provide liquidity to aggressive
but apparently uninformed individual investors.
Well, these data should be discouraging.
A 2012 study titled the cross-section of speculators skill
evidence from day trading,
examined the distribution of outcomes for day traders.
Sure, on average day traders trade the market after costs,
which just makes sense.
But to the best day traders consistently make money
again using Taiwanese data this time between 1992 and 2006
the authors find that less than 1%
of the total population of day traders is able to reliably
earn positive excess returns after costs.
In the average year in their sample
about 450,000 Taiwanese individuals engage in day trading,
while only between 1000 and 4,000 of them,
depending on the assumed level of trading costs,
that is between 0.22% and 0.9% of the 450,000
earned consistent alpha after costs.
It is important to point out that the top 500 day traders
the top 0.1% do persistently earn very large alphas
of about 38 basis points after costs per day.
The authors show that this result is partially
but not completely explained by chance,
meaning that there is evidence of a very small number
of skilled traders within their sample.
We have now seen that well day trading is harmful
in aggregate mostly due to costs.
There is meaningful variation in the cross section
of investors ability to be successful in day trading.
A small, tiny really subset of day traders in Taiwan
from 1992 through 2006,
did exhibit an ability to earn consistent profits.
Maybe there is hope for day traders.
At least there was hope in Taiwan from 1992 to 2006,
the world has changed a lot since then.
A more recent study titled "Day trading for a living"
examined all individuals who began to day trade
between 2013 and 2015 through the end of 2017
in the Brazilian Equity Futures Market.
The third largest in terms of trading volume in the world.
They found that of the 19,646 new day traders in the sample
5.7% of them day traded only one day,
50.8% between two and 50 days, 15.8, between 51 and 100 days
13.9% between 101 and 200 days
5.9% between 201 and 300 days
and 7.9% traded for more than 300 days.
They found a monotonic decrease in the probability
of profit with an increasing number of active trading days.
In other words, that traders who traded more often
will less likely to be profitable.
Of the 1,551 individuals who day traded
for at least 300 days,
they found that 97% of them lost money.
1.1% of them earn more than minimum wage.
0.5% of them earn more than a bank teller salary
and the single best day trader
earn 310 US dollars per day on average,
with a lot of daily variants.
They also ask whether there is learning among day traders.
If there is learning
the bad day traders should self-select out
while only the good ones continue to trade
and increasingly improve,
they find no evidence of learning.
Instead observing patterns
that usually found in gambling activities
where the proportion of successful players
also monotonically decreases
with the number of rounds played.
The authors of this paper suggests
that a possible reason for their finding diverging
from the previous evidence of a few day traders in Taiwan
earning large excess returns
is the during the 1992 to 2006 sample,
retail day traders did not have to compete for profits
with institutional high-frequency trading algorithms,
which are increasingly prevalent in today's market.
This suggestion brings up an important concept in trading.
The paradox of skill,
this term was coined by Michael Mauboussin
and is explained in detail in a Credit Suisse research note.
Mauboussin uses the example of Ted Williams,
who was the last player in major league baseball
to hit over 400 for a full season in 1941.
Baseball players have gotten better over time
not to mention the use of performance enhancing drugs.
So why hasn't anyone been able to match Williams?
The answer lies in the two dimensions of skill.
Skill can be viewed as absolute and relative
in absolute terms today's athletes
are more skilled than athletes of the past.
They are better trained, better coached
have superior nutrition and come from a larger talent pool.
If one of today's best baseball players
went back in time to 1941,
they would likely have an easy time
matching or surpassing Ted Williams,
but today's athletes don't get to travel back in time.
There higher absolute level of skill is not an advantage
because their relative level of skill is as evidenced
by nobody matching Ted Williams lower
in a competitive scenario.
Like baseball or stock trading,
everyone is competing to find an edge.
As absolute skill increases for all participants,
relative skill is decreasing
finding that edge is getting harder
because everyone is getting better.
If two equally skilled traders are competing for an edge
the outcome will be determined by luck.
And as the skill of all traders increases
the role of luck and trading outcomes also increases.
All right I know I've painted a bleak picture
for the prospect of day traders
and rightly so because the reality is just as bleak.
So why do day traders still day trade,
a 2019 paper in The Review of Asset Pricing Studies
titled, "Learning fast or slow"
suggests three possible explanations.
First day traders may not have standard risk
averse preferences.
In other words, they seek investments
with a highly skewed outcome like lotteries.
If this is the preference that day traders are exhibiting
the author suggests that simply buying
and holding a single volatile stock
would be a better solution than day trading.
Second day traders may be overconfident
in their prior beliefs about their own abilities
and be biased in the way that they learn.
Well, now that day traders likely realize
that most day traders do lose money.
The stories of successful day traders may circulate
in non-representative proportions, giving the impression
that success is more frequent than it actually is.
And third day traders may day trade
for non-financial reasons like entertainment,
a taste for gambling or the desire to impress others.
They may enjoy the process of day trading so much
that regular and expected losses are simply the cost of it.
Mission to an enjoyable activity.
There's one final point that any day trader or stock picker
for that matter should consider.
Which stocks are you looking at and why?
It's not as obvious as it seems.
A 2007 paper in The Review of Financial Studies titled,
"All that glitters the effective attention
"and news on the buying behavior
"of individual and institutional investors"
attempted to answer the question.
The authors found that individual investors
are net buyers of stocks with high trading volume
net buyers of stocks
with extremely negative and extremely positive
one day returns
and net buyers of stocks that appear in the news.
Limiting their opportunity,
set to attention grabbing stocks,
poses a problem for individual investors.
The attention attracting qualities of a stock may detract
from their attractiveness as an investment.
The authors offer the example of a well circulated article
about a deserted vacation spot attracting the attention
and the travel plans of many vacationers
who would all be disappointed
by the crowds of like-minded tourists when they got there.
Similarly attention-based stock purchases
could temporarily inflate a stock's price,
leading to disappointing subsequent returns.
And even beyond that
there is a massive skew in individual stock returns.
Only 1.3% of global stocks were responsible for all
of the net wealth creation in excess of treasury bills
from 1990 through 2018.
There are thousands of stocks that trade across the world
but the evidence suggests that individual investors
focus on the ones that grabbed their attention
as opposed to examining the full opportunity set.
It is clear that day trading
is not a profitable activity for most people
and more trading
leads to a higher likelihood of poor performance.
The fact that a tiny fraction of day traders
exhibit skill in some samples,
should not be enough to entice rational investors to gamble
but the behavior of day trader suggest
that gambling may be exactly what they want.
If day trading stocks is the biggest casino in the world
like other casinos it is a losing game.
Since there is no evidence of learning among day traders,
paying someone to teach you how to day trade
is only making your prospects worse after costs.
Finally, individual investors tend to focus on attention
grabbing stocks instead of rationally assessing
the full global opportunity set,
this alone dramatically increases
the likelihood of trailing the market.
Thanks for watching.
My name is Ben Felix, and this is Common Sense Investing.
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someone who you think could benefit from the information.
And don't forget
if you've run out of Common Sense Investing videos to watch,
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of the Rational Reminder podcast
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