Trading is Hazardous To Your Wealth
By Mitchell S. Ostwald
Recently, two UC Davis Graduate School of Management students had a paper published in the Journal of Finance. The title is Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors". For day traders, the analysis is not encouraging.
They concluded that "Individual investors who hold common stocks directly pay a tremendous performance penalty for active trading. Of 66,465 households with accounts at a large discount broker during 1991 through 1996, those that trade most earn an annual return of 11.4%, while the market return is 17.9%. The average household earns an annual return of 16.4% common stock investment towards high-beta, small, value stocks and turns over 75% of its portfolio annually. Over confidence can explain high trading levels and the resulting poor performance of individual investors. Our central message is that trading is hazardous to your wealth. "
In support of their conclusion, they analyzed a unique data set that consists of position statements and trading activity for 78,000 households at a large discount brokerage firm over a six year period ending in January 1997. The most dramatic and empirical evidence these researchers found supports the view that over confidence leads to excessive trading. They found that "though liquidity, risk based rebalancing and taxes can explain some trading activity, we argue that it belies common sense that these motivations for trade, even in combination, can explain average annual turnovers of more than 250% for those households that trade most. " Conversely, they did find that there was very little difference in the gross performance of households that trade frequently (with monthly turnovers in excess of 8.8%) and those that trade infrequently.
This study is believed to be the first comprehensive study of the common stock performance of individual investors who manage their own equity investments without the advice of a full service broker. At first glance, this would support the conclusions that SEC chairman, Arthur Levitt has repeatedly brought against the online brokerage firms as a result of their deceptive and highly controversial ad campaigns. One only needs to remember the "monkey and two idiots" ad during the Superbowl or the most recent advertisement of the man with "money coming out of his wazoo".
Both the conclusions reached in this study, as well as those stated by Chairman Levitt, again document that people tend to be over confident in trading. Because the theoretical models suggest that active traders will have a much lower yield, then active traders must earn higher expected gross returns in order to offset their greater trading costs. This suggests an errant trading method akin to gambling; increasing one's bet in order to make up for losses. This approach to investing starts to sound very similar to Chairman Greenspan's comments of "irrational exuberance. "
As we enter into a period of time where securities do not always continue to go up, where steep declines can occur in as little as a 3 to 5 day period, it is important for all investors to take "stock" of their own portfolios, re-evaluate their risk tolerance, their objectives, and whether their methods of trading are indeed a long-term tool for achieving wealth and financial independence.
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