by Paul B Farrell, JD, PhD
Behavioral finance researchers have studied the performance of stock market traders in both America and Asia. Interestingly, they discovered that traders in both countries under-perform the world’s broad markets by significant amounts. One study analyzed 66,400 accounts at a major Wall Street firm over a seven-year period. Another studied all the active traders on the Taiwan, China exchange.
In spite of the cultural differences, the results were virtually the same. Why? Due to the high transaction costs, taxes and bad decisions, the bottom line is simple: “The more you trade the less you earn.” In fact, about 80% of all day traders lose money. In researching the Americans, the study found that the active investors who turned over their portfolios 258% annually made less than 12% on their money. Passive investors who bought and held, with only 2% portfolio turnover, had average returns of roughly 18%, which is about fifty percent higher than the returns of the active investors. Still, investors believe they can “beat The Street,” simple because the Wall Street “Hype Machine” has programmed them to believe that myth.
It was billed as a “debate,” on a nationally syndicated show. Me, a buy’n’holder to the core, versus John Mauldin, author of the Bull’s Eye Investor and Millennium Wave Investments, a newsletter publisher and investment adviser. John’s a guy who’s not only pro-trading, he hates a buy’n’hold strategy with a passion. So why’s he against buy’n’hold? Well, a good part of the reason is he believes the market’s going nowhere for the rest of this decade, maybe longer. Volatile, risky, unpredictable. But, he ‘s convinced that by using active and aggressive strategies, you can beat the market.
Mauldin is so thoroughly convinced that if you don’t give up on a long-term buy’n’hold strategy and actively engage in alternative strategies (such as hedge funds, gold stocks and trading in value stocks), you’ll lose a lot of money and retire a pauper. So, who won the debate? Buy’n’hold or the hyper-active Bull’s Eye Investor? Nobody! In fact, nobody ever wins this debate. Nobody. Ever!
Different DNA? Then you better play a “different game”
Why? Probably because over ninety percent of American investors are born with a buy’n’hold gene. They are born as passive investors who instinctively tend toward well-diversified portfolios of low-cost index funds. They don’t have the time, or money or the interest in active portfolio management, nor do they trust in the market or in professional market experts.
Meanwhile, the DNA of other ten percent or less—those macho “Bull’s Eye Investors”—contains a rare over-confidence gene that pumps an “I’m-convinced-I-will-beat-the-market” drug directly into their veins and brains. Of course the odds are against them beating the averages, but that gene also contains a blocker that suppresses contrary negative information—even when they’re on a losing streak. The brain chemistry and psychological profiles of these two types of investors are world’s apart. If you listened to a debate between passive Main Street investors and Bull’s Eye Investors you’d think you were talking to two aliens, one from Mars, the other from Venus.
Warning, 82% of all day traders are losers! But deny it!
Moreover, never the twain shall meet. Each type of investor is as dogmatic as the other. DNA-based ideologies control each one, not rationality. Why? Their minds are made up in advance. Their opinions and beliefs were already cast in stone long ago. To each, facts about the other are totally irrelevant. Indeed, that was a given from the start, as I found out once again in our so-called debate. Here’s why: Just before this little debate we discovered some interesting new data from a BusinessWeek article.
The bottom line is simple—most traders are losers. Earlier, Forbes reported on a study that the “North American Securities Administrators found that 77% of day traders lost money.” Now comes more evidence, BusinessWeek was reporting that 82% of all day traders lose money. That data comes from a recent study by a couple professors at the University of Taipei working in conjunction with University of California behavioral finance professors Terry Odean and Brad Barber. And yes, that is the same Odean and Barber who researched 66,400 Wall Street investors a decade ago and concluded, “The more you trade the less you earn.”
In fact, their earlier study proved that the returns of passive buy’n’hold investors (with just two percent turnover) were a whopping 50 percent higher than the returns of the most active traders (averaging 258 percent annual turnover). Why? Very simple, transaction costs, commissions and taxes were killing returns.
In the new study four behavioral finance professors had access to all the records of the Taiwan Stock Exchange (TSE) for the 1995-1999 period. Not just 66,400 randomly selected accounts in Wall Street’s huge database of millions of clients, but all 100 percent of the traders on TSE, including their identities, a total of 925,000 investors. Assuming the DNA of a Taiwanese trader is essentially the same as the DNA of a trader at Goldman, Morgan or Merrill, the new Odean-Barber study results actually confirm what we already know, that market timing and day-trading are a loser’s game.
Dumb and dumber—and yet, they can’t stop losing
All this research also shows that the most active traders—a small group equaling about one percent of all traders—actually accounted for over half of all the exchange’s volume. However, while those guys did make money in their trading—after transaction costs were deducted they were net losers. The study actually went much deeper: Listen to this new bit of information about the strange self-sabotaging obsession traders have to lose money: The study separated the traders into six groups depending on their past successes. The researchers wanted to see if past winners repeated. The answer was yes, but at a very high cost:
– The average winning trader did in fact repeat as a winner, netting $251 a day after transaction costs. But overall, things were so bad that 82% of all the traders lost money, for an average loss of $45 a day.
– That’s right: Out of 925,000 traders in the study, about 750,000 of them were losers. And assuming 250 trading days a year, each trader lost roughly $11,250 a year for a total loss of about $8.4 billion annually.
– On the other hand, the 175,000 repeat winners each made an estimated $62,750 a year after transaction costs, for a total annual gain by the winners of roughly $11 billion. So even the small number of the top-performing traders made only $62,750 a year for all their risk-taking.
Big deal? It gets even worse. Remember, those study covered the manic trading days of the late nineties. Those were the heady go-go days of the great bull market when even 30 percent returns on funds were considered so-so. Those were the days when over a couple hundred funds generated returns in excess of 100 percent in 1999, many over 300 percent—the days when few lost money.
Chimp makes chump of best day-traders
Let me remind you of one very unique “competitor” in the trading world at the time: Raven the chimpanzee! Raven created a winning portfolio by throwing darts to pick stocks—regularly beating even hot portfolio managers returning 300% annually on the Monkeydex portfolio. So the joke’s on all of America’s hot-shot traders. And just in case you think this is just a cute joke, for several years The Wall Street Journal ran a regular contest pitting dart-throwing versus picks based on a comment made by Princeton Professor Burton Malkiel in his classic, A Random Walk Down Wall Street: “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by the experts.”
In short, the new study is a huge embarrassment for the online discount trading firms, for example, who hype the payoffs from trading. Unfortunately, their trader-clients are not only big losers, the 82 percent who are repeat losers are so blind and dumb that they stay in this loser’s game, in denial, and just kept on losing. That’s the trader’s DNA at work!
Dumb, dumber … now the dumbest
Worse yet, the “winners” were the dumbest of all. The so-called winning traders were not only making less than Raven the monkey, they were making less than a buy’n’hold investor would have made from a portfolio with a thousands just sitting passively in tech funds and stocks in the 1995-1999 period. So once again our hat’s off to Odean and Barber, their two studies confirm the truth about trading, that … trading is a loser’s game.
The only people who really make money trading on a regular basis are the service professionals, especially the commission brokers. These pros make their commissions no matter how much investors and traders lose. Even in bear markets their ads paint a deceptive picture aimed at the wannabe trader’s super-confident but addictive and self-sabotaging genes—ads designed to convince naïve wannabe traders that the pros have some special secret that’ll beat the market—secrets they’re willing to share for a fee, naturally.
The truth is: They can’t … they never do … and they never will beat the market … no matter how long they try … trading’s a loser‘s game. But as I found out one more time in this “debate,” as I do in every “debate” with an expert who may be making a living selling trading secrets … I may as well have been trying to convince Raven the chimpanzee that eventually he too would lose, and lose big.
In that respect however, chimpanzees are superior to human traders. The trader’s DNA control their brains, they have no choice but to keep chasing the impossible dream that they can beat the market. The truth is, they’re addicted to losing. The pros know this, so they can take advantage of the wannabe traders never-ending delusional “winner’s fantasy.” And the game goes on ad infinitum, with the pros having a big laugh as they rake off big fees and commissions and get rich off the 82 percent of all traders who are repeat losers.