Friday, January 25, 2008

The Most Important Reason Individual Investors Lose Money

Trading coaches and psychologists are particularly apt to speculate as to the major reasons traders and investors lose money. Among the usual suspects are: failure to plan trades or operate from a trading plan; loss of discipline with respect to risk management; impulsive (over)trading; and failure to trade reliable, tested ideas. Having worked with quite a few traders and portfolio managers, I can vouch for all of these as valid reasons for poor performance among traders.

I was very interested to see, therefore, that recent research identifies a different factor as a signature reason for the failure of individual investors. A 2006 study by Brad Barber, Yi-Tsung Lee, Yu-Jane Liu, and Terrence Odean, entitled "Just How Much Do Individual Investors Lose by Trading?" finds that losing market participants owe much of their losses to the way in which they execute their trades.

Studying five years of trade-by-trade history for the Taiwan Stock Exchange--a mammoth undertaking--the authors find that individual investors overall not only lose money, but lose significant sums. Overall, the average annual loss from trading from the individual investors was -3.8%. This is not a small sum; it represents 2.2% of the entire GDP of Taiwan.

Conversely, institutional market participants averaged a gain of 1.5% per year after trading costs were factored in. A large body of research reviewed by the authors confirms this finding: over time, individual investors tend to lose money; institutional ones tend to be profitable. (As mentioned in my recent post, there is a small group of individual traders that appears to be consistently profitable after expenses; one can also find unsuccessful traders at various banking and financial institutions).

The surprising finding from the study is that virtually all of the losses of individual investors can be attributed to their use of aggressive orders. In other words, they are trying to buy into strength and sell into weakness. At short time frames, the institutions derive significant profit from their use of passive orders: buying bids and selling offers. "The profits associated with passive trades," the authors explain, "are realized quickly, as institutions provide liquidity to aggressive, but apparently uninformed, investors."

This very much fits with my experience: in the recent U.S. markets, much of this profiting from the provision of liquidity close to the market is accomplished by algorithmic (automated) trading. (When I first began working with traders in Chicago it was more common to see individual traders at proprietary firms providing this liquidity close to the market. Such scalping has become less profitable on average for traders as computers have speed of computation and execution on their side. Nonetheless, this has simply changed *who* is benefiting from passive orders, not whether such orders are effective in the very short run).

Supporting the idea that execution is crucial to the success or failure of individual traders is the finding that the average returns of individual traders are negative over time horizons of one to ten days, but close to zero 25 days and out. In other words, the individual traders are tending to lose money on their shortest-term trades. Getting a bad price due to aggressively entering markets could be a reason for that: it would lead to a greater probability of a trader's getting stopped out of positions.

Interestingly, over those short time horizons, the passive trades of individual traders tend to be profitable. The advantage of executing with passive orders tends to erode over time. When, however, the individual trader executes aggressive orders, these have resulted in significant losses. The authors speculate:

"Apparently, individual investors are demanding liquidity when they have no information about the future prospects of a stock. This observation is quite consistent with models that assume investors are overconfident and, as a result, trade too aggressively and to their detriment. In striking contrast, institutions immediately profit from their aggressive trades and these profits grow dramatically at longer horizon--perhaps as the information that institutions possess about the prospects for a stock are more widely appreciated by market participants."

By executing trades aggressively, the active trader immediately loses a tick; were he or she to turn around and immediately unwind the trade, they would be out the bid/offer spread. Those ticks add up. A trader who trades five-lots just once a day in the ES (S&P 500 e-mini futures contract) on a portfolio of $50,000 would lose five ticks a day just through aggressive entries. Over 250 trading days in a year, this would lead to a loss of more than 300 ES points or $15,000--30% of the trader's portfolio! What this points out is that an individual trader who executes aggressively in markets with relatively wide bid-offer spreads needs to be quite successful in order to just break even after a year.

The research suggests that aggressive trading of markets can be successful if traders possess unique, valuable information. In the absence of such information, it seems as though chasing rising and falling markets, on average, enriches the market makers who profit from the bid/offer spread and their ability to control movement close to the market with their large size. It's not just the idea you trade, but how you execute the idea--and how consistently you execute well--that seems to matter in the long run.

RELEVANT POST:

Pervasive Myths of Trading Psychology
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