The Truth About Day Trading

Summary

In this episode of Common Sense Investing, Ben Felix examines the effectiveness of day trading, highlighting the overwhelming data showing that most day traders underperform the market, often due to high transaction costs, overconfidence, and competition with institutional investors. Studies reveal that while a tiny fraction of traders may achieve consistent profits, the vast majority lose money. Felix emphasizes the parallels between day trading and gambling, cautioning against paying for trading courses and urging investors to consider the broader market rather than attention-grabbing stocks.

Takeaways

• 📉 Day trading is generally ineffective as a strategy and often leads to losses due to transaction costs.
• 💰 Studies show that most day traders underperform the market, with frequent traders losing more annually.
• 🔍 Data from a Taiwanese study found that individual investors reduced their aggregate portfolio returns by 3.8% annually through day trading.
• 📊 Only a tiny fraction of day traders (less than 1%) are able to earn consistent positive returns after costs.
• 🏦 Institutions tend to benefit from day traders' losses, often by providing liquidity in trades that individuals make with urgency.
• 📉 A Brazilian study found that 97% of day traders who traded for at least 300 days lost money, with very few earning even modest profits.
• 🎲 Day trading has similarities to gambling, where the more frequently one trades, the more likely they are to lose.
• 💡 The 'paradox of skill' implies that as absolute skill among traders increases, luck becomes a bigger factor in success.
• 📈 Day traders tend to focus on attention-grabbing stocks, which are often poor investments due to temporary price inflations.
• 🧠 There is no significant evidence of learning among day traders, meaning paying for day trading courses may worsen the outcome.

Q & A

What is day trading and why is it considered appealing to some investors?

Day trading involves buying and selling the same financial asset within the same day to make quick profits. It appeals to some investors because it promises the potential for daily profits, which seems more exciting and profitable compared to long-term investments like index funds.

What do studies say about the effectiveness of day trading as a strategy?

Studies show that day trading is largely ineffective for most individual investors. Research has found that individual investors often underperform the market, with transaction costs and frequent trading leading to average losses. Only a very small percentage of day traders are consistently profitable.

Why do researchers believe that individual investors underperform when day trading?

Researchers attribute underperformance to overconfidence and excessive trading. Investors overestimate the value of the information they have, leading them to make frequent trades that incur high transaction costs, which reduces their overall returns.

What were the findings of the 2000 paper titled 'Trading is hazardous to your wealth'?

The paper examined data from 66,465 households and found that individual investors earned returns close to the market average before costs but trailed by 1.1% annually after costs. The households that traded more frequently trailed by 5.5% annually, with poor performance attributed to transaction costs and risky stock selections.

How did the performance of day traders in Taiwan between 1995 and 2019 compare to that of institutional investors?

Day traders in Taiwan reduced aggregate portfolio returns for individual investors by 3.8% annually. The majority of these losses came from trading losses, commissions, and market timing. Meanwhile, institutional investors profited from passive trades, often providing liquidity to individual traders who acted with urgency.

What percentage of Taiwanese day traders were able to make consistent profits after costs?

Less than 1% of Taiwanese day traders between 1992 and 2006 were able to consistently make profits after costs. Specifically, only about 0.22% to 0.9% of traders earned consistent positive returns, and the top 0.1% of day traders were able to earn significant profits.

What were the findings of the 2017 study on day traders in Brazil?

The study found that among 19,646 new day traders in Brazil between 2013 and 2015, 97% of those who traded for more than 300 days lost money. Only 1.1% earned more than the minimum wage, and just 0.5% earned more than a bank teller's salary. This study found no evidence of learning or improvement among day traders.

What is the 'paradox of skill' and how does it apply to day trading?

The 'paradox of skill' suggests that as the skill levels of all participants increase, relative skill decreases, making it harder to gain an edge. In day trading, this means that as traders become more skilled and use better tools, luck plays a larger role in determining success, reducing the likelihood of consistently outperforming the market.

Why do some day traders continue despite the low chances of success?

Day traders may continue trading for reasons beyond financial gain. They might enjoy the process as a form of entertainment, have a taste for gambling, or be overconfident in their abilities. They may also be influenced by stories of success, which circulate disproportionately, making it seem like day trading success is more common than it actually is.

What impact does focusing on attention-grabbing stocks have on individual investors?

Focusing on attention-grabbing stocks, like those with high trading volume or that appear in the news, often leads to poor investment decisions. These stocks can experience temporary price inflation, which can result in disappointing returns for individual investors.