To eliminate first time dabblers Hieronymous eliminated all accounts that ceased trading after only a short time. Traders who had made more than 10 trades over the course of the year or had losses or gains in excess of $500 were tallied.
In the group of regular traders it was found that 41% of the regular traders made money during the year. The majority won or lost a moderate sum of $3000 or less (but this was 1969, so adjusted for inflation the figure is more respectable), although some made or lost much greater sums. Overall the market showed its zero-sum nature because in this group the net profits were approximately zero, so 41% of traders took money from the remaining 59%. The one-timers lost 92% of the time.
The lesson? A lot of people enter unprepared, take a loss and then quickly leave with burnt fingers. Those that stick around to play the game can be winners, but not the majority.
This study found that 18 of the 26 accounts lost money. In addition, risk of ruin calculations on the trader's statistics found that in theory, three quarters of the sample were headed inexorably toward failure, with a 100% risk of ruin.
Furthermore, the 8 accounts that were profitable also had a very high risk of ruin. Only three of the eight accounts that made any money had a risk of ruin low enough to imply any significant success as a speculative trader (under 25%). For example one of the winning accounts made 93% of his/her total profit on just one trade ($7,650), without that trade 99 other trades would have netted only $610 in total, indicating that luck may account for much of this performance.
The most successful trader in the group had an average holding period of 47 days, and did not day trade. (The other accounts not accounted for as winners or losers only had a couple of transactions and were not statistically valid).
Conclusions of this study: the great majority of traders surveyed had a risk of ruin so high as to make eventual bankruptcy virtually inevitable. The traders with the shortest time frames (day traders) lost the most money and had the highest risk of ruin.
The report also found that the average holding time for winning trades was much shorter than the holding time for losing trades, indicating that traders were cutting their winners early but letting their losses run.
The study ignored the effects of tax, and did not comment on whether or not the few winners actually performed better than index funds, merely whether they were profitable or not in absolute terms.
The Johnson Report is interesting, but for sheer volume of data Odean and Barber give a much more convincing argument.
Later, Odean repeated this study on a much larger scale, in the repeat he examined the accounts of 66,465 households from 1991 to 1996. So in total, he looked at a huge number of accounts, and a vast number of trades. The conclusions from each study were virtually identical: trading hurts your wealth.
Odean found that as a group all amateur investors underperform the market due to higher than necessary trading costs. But the 20% of traders with the highest turnover underperformed the most. In the sample, while the market went up an annualised 17.1% over the period, the average investor/trader with a turnover of 80%pa returned 15.3%, but the 20% with the highest turnover, 283%pa on average, got only 10%pa.
This study was performed with the clients of a discount (non web) brokerage. How would the figures change for the ultra cheap Internet brokers?
According to Odean, not very much. Commissions were an important part of the reason why active traders had the worst performance, but the main bogeyman was the bid/ask spread. In fact Odean believes that traders as a group are now doing even worse than they did in the old discount brokerage days because turnover has increased even more.
Odean offers the following example: The average trade in his sample was roughly $13,000 in size. Trading through a discount broker, an investor might have paid $60 or so in commissions "round-trip," or $30 for the buy and $30 for the sale. But by Odean's estimate, the typical investor also lost a full 1% to the bid-ask spread -- or $130 on this typical $13,000 purchase.
If this investor switches to an online broker that makes trades for only $10, the "round-trip" cost of the trade falls to only $20 -- but the spread still amounts to a loss of $130, for a total transaction cost of $150.
No doubt $150 is cheaper than $190 but it's only around 21% less, not the 66% that investors might believe that he or she is saving. And even this 21% savings could be swallowed up if investors choose to change their behavior and trade more frequently as a result of the lower commissions.
As a matter of fact, Odean did find a tendency to trade more when traders switched to cheap web brokers. In the second study he examined the trading records of 1,600 traders that switched from discount telephone trading to deep discount web trading. He found that turnover increased by a third and traders doubled their exposure to "speculative" stocks. That is to say that telephone traders were twice as likely as web traders to buy large stocks, compared to web traders that on average concentrated more on small speculative stocks trading on the NASDAQ and other minor exchanges.
The most interesting finding of Odean's research is that traders underperform as a group even after taking out trading costs. On average, the stocks these traders sold outperformed the market, and those they bought underperformed the market. One year after each trade, the average investor wound up more than 9% poorer than if had he done nothing. Two years later, the results were even worse.
Odean found that if the traders had not turned over their portfolios, they would have done much better. In fact as a group they tended to buy small company and value stocks, which at the time were a profitable sector. The stocks they picked on average did in fact outperform the market, but traders snatched defeat from the jaws of victory by systematically selling their best stocks early and holding their worst stocks too long.
Why were traders doing so badly? Odean believes there are several reasons. First, most of the traders were buying stocks that had either risen or fallen substantially in the six months prior to buying. Since there are too many stocks to follow, most traders jump into ones that catch their eye due to their sharp moves or media attention. Momentum traders jump in on the biggest gainers and bargain hunters pile in on troubled issues. In both cases they are dealing in a relatively small number of issues in the public eye, and following a crowd is rarely a successful trading strategy.
Another finding was that the traders in the group had a strong tendency to sell the wrong stocks. Odean says traders "strongly prefer to sell their winning investments and hold on to their losing investments, even though the winning investments they sell subsequently outperform the losers they continue to hold." Selling a loser amounts to admitting you have made a mistake. Traders hate that, they much prefer to sell stocks at a profit, which makes them feel like a winner, as a result traders systematically weeded out good stocks from their portfolios and retained poor ones.
Odean later repeated this research with a substantially larger sample size.
Odean's later study confirmed a strong correlation between the amount of trading investors did and their returns. Hyperactive traders, with an average of 1,000% annual turnover, had just a 11.4% annualized return after expenses. The least-active investors barely traded, changing just 2.3% of their holdings annually, yet they managed a market-beating 18.5% annualized return (the S&P 500 Index was up 16.9% annually during the period). Note that these figures do not include the tax penalty paid by heavy traders.
But what if hyperactive traders tended to pick worse stocks, such that their lower performance was due to this, rather than their trading? Not so, according to the study. Had the least-active traders done no trading, their returns would have only been 0.25% better annually, whereas the heavy traders would have done more than seven percentage points better annually.
Not surprisingly, Barber and Odean concluded, "Our central message is that trading is hazardous to your wealth."
Terry Odean's home page, with most or all of his papers is at http://faculty.haas.berkeley.edu/odean/. It is definitely worth reading through his papers, even if you do intend to trade you'll find his insights into why people were underperforming valuable.
The investors' main problem was that they were performance chasers. They moved their money into the funds with the highest past performance and stampeded for the door when funds underperformed. Usually this meant "buy high, sell low". Dalbar's conclusion was:
Mutual fund investors earn far less than reported returns due to their investing behaviour. In their attempt to cash in on the impressive stock market gains, investors jump on the bandwagon too late, and switch in and out of funds trying to time the market. By not remaining invested for the entire period, they do not benefit from the majority of the equity market appreciation.
How bad was this underperformance? Well, thanks to all the hard work, technical analysis and fundamental research American mutual fund investors put in, over a seventeen year period ending in 2001, the average equity investor only earned approximately six percent of the gain of the S&P 500!
Interestingly, in the 1993 version of the study Dalbar divided investors into two groups: "sales-force advised" and "non-advised". The study then examined the investment results for both equity and bond funds for a ten year period (January 1984 to September 1993).
The first group were the clients of financial advisers, the latter were DIY investors. The result, which has obviously been milked for all it was worth by the financial advisory industry was that the advised group had a total return of 90.21 percent while the do-it-yourselfers got only 70.23 percent. Dalbar observes, "The advantage is directly traceable to longer retention periods and reduced reaction to changes in market conditions."
The industry made a lot out of those findings, but I have a bombshell for both groups: over this same period, the S&P500 index returned 293%! So we have a hierarchy here, apparently professional advisers beat amateur investors, which one probably should not find too surprising, but index funds beat professional investors by a much bigger margin.
Trading is a negative sum game. There are two ways to beat an index fund, which I take to be the standard investment strategy anyone can use and therefore a viable alternative to speculative trading:
Successful, above average individuals only exist at the expense of unsuccessful below average individuals. Clearly it is impossible for everyone to be above average, so bear this in mind, on average the whole group will get index performance, minus costs. It is mathematically impossible for there to be any more than a very small number of people to beat indexes because trading is expensive.
If trading didn't cost anything, half of all traders would beat the index and half would lose (either that, or a few would make a lot and the majority would make only a little bit less than average). But as I've said, trading is very expensive, and the more a group of traders trade the worse their collective performance. Sure, some trading genius may still do well, but only because the vast majority of traders are losing a lot of money.
Many aus.invest readers refer with contempt to unsophisticated traders, calling them "cattle" and "cannon fodder" and other names. Clearly these readers have a very high opinion of themselves, they feel they are members of that elite.
But... to 8,000 hedge funds and many times that number of full time professional traders, brokers and money managers, it is the millions of little guys out there armed with a copy of Metastock and a few Daryl Guppy books that are the fodder. This includes aus.invest readers, including many of the people there that ridicule indexing.
I have another disappointment for you: the tax system penalises traders. If you hold a stock more than one year you pay capital gains tax at half your marginal tax rate, but sell before 12 months and you pay CGT at your full marginal tax rate.
Not only does your chance of above average performance dramatically decrease when you trade, but you get slugged with tax at twice the rate. We know that only a very small proportion of traders do better than passive index fund investors before tax, but factor in the tax penalty and you'll see that it becomes even harder.
Taking into account taxes, for a trader to do nothing more than simply match the after tax return from index fund investment it is not sufficient to beat the market by a small amount, it is necessary to comprehensively trounce it. To beat an index fund after taxes you must massively outperform the index with your trading. We know that only a minority of traders are going to outperform the index at all, but how many will massively outperform? No doubt by now you'll get the message I'm trying to convey: not many at all.
So it is obvious you have practically no chance of beating the market by trading. The probability of you succeeding in this, to the extent of achieving the apparently modest goal of beating a lazy index fund investor after tax, is virtually nil.
If you like those odds, and apparently most aus.invest readers love those odds because most of them mock the idea of settling for mere index returns, then read on.