So, You Want to be a Day-trader
Q: My wife and I have had some success trading stocks and we want to start doing it full-time. I believe we have sufficient capital and we’ve been taking an online course through a reputable discount brokerage firm. What advice can you give me (other than telling me not to do it)?
A: I don’t want to sound negative, but you need to understand that the odds are against your success. I’m not saying you won’t be successful. Some people are able to make a living trading stocks for their own account. However, there is a long-running debate as to whether those who succeed are talented or if they are simply lucky. As I see it, the evidence seems to point toward luck over skill.
Several academic papers have looked at the track records of day-traders and active individual investors. I understand the difference between day-trading and active management, but I am going to include both in this column because those who study both arrive at very similar conclusions.
If you were to plot the performance of all active managers and traders on a chart, the distribution of their returns would look like a bell-shaped curve. Some managers would show really strong performance and others would show really poor performance, but most would lie somewhere around the average. By comparing this average with the performance of the benchmark index you could measure how much value active managers and traders add or subtract by their stock selection and trading activities.
Several studies have done this. One such study was published in the Journal of Finance by Brad Barber of UC Davis and Terrance Odean of UC Berkeley. They reported that the average individual investor underperformed the market index by 1.5% per year, while active traders, as a group, underperformed by 6.5% annually. Interestingly, these same authors reported in a later paper that women traders outperformed their male counterparts, though both women and men did worse than the market index.
Another study showed that the proportion of active managers who outperformed the market benchmark was significantly smaller than one would expect if the distribution of returns was purely random. In other words, active managers as a group have not beaten the market and fewer active managers than expected have demonstrated superior ability.
Other studies have explored the reasons why individual investors tend to underperform. One reason is transactions costs. Too frequent trading can result in transaction costs that swamp the gains they earn by trading.
Taxation is another problem. Since most day-trading occurs in taxable accounts, every trade carries a significant tax burden. Even a skilled trader will find the tax rates on short-term capital gains to be a formidable barrier to better-than-benchmark performance.
Another significant cause for underperformance is overconfidence. Several academic studies show that individual investors tend to believe they know more than they do and they tend to overestimate their ability. Those who overestimate their ability the most also tend to trade the most.
Finally, investing is largely an information game. The internet has done much to level the playing field, but small traders and investors are at a huge information disadvantage compared to Wall Street firms, hedge funds and institutional managers. One author compared trading against these firms to playing tennis against a random draw of the top pros. Before you become a full-time day-trader, you should carefully consider if you are ready to go up against the stock market equivalent of Roger Federer.
For these and several other reasons, I believe most people are better off staying away from day-trading or actively managing their portfolios. Investors have a greater chance of success by building well-diversified portfolios of passively-managed, low-cost investments and holding them for the long-term.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940
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