- 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. (upbeat music) 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. If you enjoyed this video,
please share it with 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, you can tune into weekly episodes of the Rational Reminder podcast wherever you get your podcasts. (upbeat music)
