Stags

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  By Guest Blogger Doug Rowat

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Me highlighting charts similar to the one below at least once a year is about as automatic as Billy Joel playing “Piano Man” at a live show:

Staying invested: the best long-term strategy

Source: Calamos Investments

Like Billy, I know what my audience needs to hear and, yes, in the long run, the best performing portfolio is one that’s low turnover. Missing only the best 10 market days potentially cuts your accumulated wealth by more than half versus being fully invested. Thank you. Good night. Drive safely.

However, what I’ve never examined here before is the opposite end of that investing spectrum: rather than maintaining a low-turnover portfolio, what advantage might there be for an investor to instead trade the bejesus out of their portfolio?

Recently, I had lunch with a few Bay Street colleagues, and we discussed the recent spike in market volatility with the Cboe Volatility Index (VIX) soaring to nearly the 66 level on August 5. It was a 42-point intraday move and it marked the largest intraday jump in the VIX’s history. My colleagues mentioned that a few of their day-trading clients did well that day as volatility often works to the benefit of day traders.

But one profitable day doesn’t mark a successful investor. So, with this in mind, what’s the true, long-term track-record for day traders?

First, according to FINRA, the big US financial-industry regulator, a day trader is defined as an investor who executes four or more “day trades” (buying and selling a security the same day) within five business days. However, most day traders execute many more trades than this over five days. Not surprisingly, FINRA cautions that day trading is not just risky, but “extremely risky”, and the numbers back this up.

Much academic research has been conducted on day-trader performance, but the one consistent finding is that the overwhelming majority either vastly underperform benchmarks or outright record net financial losses.

However, perhaps the most notable research on trade frequency and its relationship to diminishing returns was conducted by Brad Barber and Terrance Odean at the University of California, Berkeley. In a 2000 study that tracked the trading patterns and performance from 1991 to 1996 of more than 66,000 households at a major discount brokerage, those that traded the most paid a “tremendous performance penalty for active trading”. Trading frequency was segmented into quintiles with each higher-turnover category experiencing increasingly weaker returns. The highest turnover quintile was a doozy:

Our most dramatic empirical evidence is provided by the 20 percent of households that trade most often. With average monthly turnover in excess of 20 percent, these households turn their common stock portfolios over more than twice annually. The gross returns earned by these high-turnover households are unremarkable, and their net returns are anemic. The net returns lag a value-weighted market index by 46 basis points per month (or 5.5 percent annually). After a reasonable accounting for the fact that a high-turnover household tilts its common stock investments towards small value stocks with high market risk, the underperformance averages 86 basis points per month (or 10.3 percent annually).

Our main point is simple: Trading is hazardous to your wealth.

Now, a high-turnover portfolio doesn’t, in a strict sense, equate to day trading, but the steady deterioration in performance as trade frequency increases is telling.

However, in later research, when Barber, Odean and other academics actually did examine only day-trading activity, specifically using Taiwanese Stock Exchange data from 1995 to 1999, the aggregate results for these active traders were still dismal:

Our main empirical findings can be summarized succinctly. Heavy day traders appear to trade at favorable prices, but only a select few are sufficiently savvy to consistently earn profits net of their trading costs. More than eight out of ten day traders lose money in a typical semiannual period.

Finally, follow-up research on the Taiwan study drew another interesting conclusion: the day trading produced behaviour consistent with gambling addiction:

Previously unprofitable traders with 50 or more days of past day trading experience have a 95.3% probability of day trading again in the next 12 months, while previously profitable traders with 50 or more days of past day trading experience have a 96.4% probability of doing so. So, not only do experienced day traders with histories of losses persist in day trading, they do so at nearly the same rate as day traders who have been profitable.

So, day trading has many potential costs, and if you do it, you should almost certainly expect to fail. Miserably.

One final note: day traders are nicknamed ‘stags’ as more than 90% of them are men.

Draw your own conclusions from that.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.