Professors of finance Brad Barber and Terrance Odean have done extensive research on the performance and habits of individual investors. Among their findings is that, on average, individual investors lose money from trading - and not all of the losses can be explained by trading costs. They've found that individual investors can have perverse security selection abilities - for example, buying stocks that earn sub-par returns and selling stocks that earn strong returns. They also have found that women produce better results than men, and that those who trade the most have the worst risk-adjusted returns. And demonstrating that more heads aren't necessarily better than one, the average investment club lagged a broad market index by almost 4 percent a year. Adjusting for risk, their performance was even worse. Clubs would have been better off never even trading during the year.
How significant are the costs of underperformance? In a study on the Taiwanese market covering the period from 1995-1999, they found that the aggregate losses of individual investors exceeded 2 percent of the country's annual gross domestic product.
The body of evidence demonstrates that even the most skilled investors have a hard time generating alpha (risk-adjusted excess returns) after all expenses are accounted for.
In their latest work, "The Cross-Section of Speculator Skill: Evidence from Day Trading," co-authored with Yi-Tsung Lee and Yu-Jane Liu, Barber and Odean studied the performance of day traders (who are almost exclusively individual investors) in Taiwan for the 15-year period from 1992 to 2006. In this case, instead of just looking at the aggregate data, they attempted to determine if there are differences in skill that are sufficient to allow persistent outperformance. They chose to look at the performance of the approximately 450,000 day traders in Taiwan because:
- They "are an important equilibrium feature in Taiwan and account for 17% of all volume on the Taiwan Stock Exchange."
- "The signal-to-noise ratio regarding investor skill arguably is greater for day traders than for investors with longer holding periods. Several prior studies document that the lion's share of abnormal returns earned around an informed trade occurs immediately following the trade. Thus, returns on the day of trade may better separate skilled and unskilled investors than long run returns."
- "Day traders trade frequently, allowing for more observations, which is likely to lead to a more precise estimate of the investor's skill."
The following is a summary of their findings:
- Consistent with prior work on the performance of individual investors, the vast majority of day traders lose money.
- There is a statistically and economically large cross-sectional variation in trader ability.
- There was persistence in performance among the top performers. This allowed them to conclude that there were some traders with skill (either that or they had inside information, or received information ahead of the general public). The top 500 day traders (based on prior year ranking) earn net abnormal returns of between 14 and 38 basis points per day (depending on the assumptions about the size of commissions) on their day trading portfolio. On the other hand, the hundreds of thousands of day traders with a history of losses in the prior year go on to earn net abnormal returns of -29 basis points per day.
Interestingly, they did find "some evidence that profitable day traders either use private information (or respond early to public information). Specifically, the returns of profitable day traders are higher in hard to value stocks (e.g., small or volatile stocks) and in periods around earnings announcements. In contrast, day traders with systematic losses also incur losses in hard to value stocks and around earnings announcements. In combination, these results suggest that day traders forecast short-term price movements in stocks or periods with high levels of information asymmetry."
The authors concluded that "while about 20% earn profits net of fees in the typical year, the results of our analysis suggest that less than 1% of day traders (4,000 out of 450,000) are able to outperform consistently." The other 99 percent would be better off abandoning their day trading efforts. In other words, day trading is hazardous to your financial health.
The historical evidence on efforts to generate alpha clearly shows that it's not impossible to generate alpha on a consistent basis. It's just that the odds of doing so are so poor it's not prudent to try. If you look in the mirror and see Warren Buffett reflected there, go ahead and try to pick stocks that will outperform. But - unless you live in Lake Wobegon, where everyone has Buffett-like abilities in addition to being strong, good-looking and above average - you're not likely to see the Oracle of Omaha looking back at you. For those of us that aren't Warren Buffett, the winning strategy is to build a globally diversified portfolio that reflects your unique ability, willingness and need to take risk. Stay the course, rebalancing and tax managing as events dictate.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.