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.


Pervasive Myths of Trading Psychology


Charles said...

It has taken me a long time to learn that when the larger time frame shows strength, to patiently wait for periods of weakness in a smaller time frame to place buy orders, and vice versa for periods of weakness in larger time frames.

Even now, it is still tempting to buy into strength and sell into weakness, even though I know that over time, it is a losing strategy.

It is an interesting human psychological weakness.


Angella said...

Excellent insight. Food for thought.


MarkB said...

Brett, you mention the topic of buying offers vs. buying bids, selling offers vs. selling bids, frequently, but I guess I have to confess some ignorance regarding this issue. If I try to buy at the bid, my order simply won't get filled, and the same is true for selling at the offer. Are you talking about, for example, setting a buy limit order at the bid and letting the market come back to my limit price?

Thanks again, your blog is one of only a few I feel I'd have a hard time living without.


Ziad said...

Insightful post. But I would have to look a bit beyond the actual stats the researchers uncovered and add some logic and experience to the conclusion. I think the key is not so much to limit one's trading to buying the bid and selling the offer, but rather to know WHEN to be aggressive and enter at market with the momentum and when to wait for the market to come to you and provide liquidity. It's not something that's easy to do at all, but it is possible.

I think the difference between the winning traders and losing ones is that the former group is much better at gauging conditions and deciding when the few opportunities exist to be aggressive and get in on momentum. At all other times they act as liquidity providers when moves extend too much in one direction. By contrast the losing traders are always chasing price action, unable to discriminate between the times to be aggressive and the times to be patient. So I don't think that buying strength or selling weakness is a losing strategy per se - you just have to know when the conditions favor such a tactic (and it's a minority of the time).

Tim said...


If you place an order to sell at the market's current offer (Ask price), you will be placed in line with all the other sellers. If enough buyers come along to buy out all of the sellers in front of you, then you will become the current offer, and you will sell at the current offer (Ask). Likewise for buying.

Whether you can create a profitable strategy using this technique is another matter, as you will be up against pros who are so concerned with 50ms network latency that they locate their computers directly at the exchange.

J said...

It is as if a chart showing price taking off in a direction makes a person confident - the move seems to confirm where things will be going, i e the conclusion "now is the time!". On the other hand, price pulling back from its recent thrust seems to be telling you "hey, this might be the start of a turning point, no good idea to try to get in (until price starts moving up again eventually, if so). It seems perfectly logical. Maybe it IS. But still, it is wrong, we are lured. More often than not, a thrust is an empty promise in terms of an entry point, and a pullback not a threat but a great opportunity to enter with large potential (both in points/ticks/pips and regarding probabilities) and with a great risk/reward ratio.

Brett Steenbarger, Ph.D. said...

Hi Mark,

Sorry for the poor wording on my part. Yes, I'm referring to place buy orders below the market and sell order above--


Brett Steenbarger, Ph.D. said...

Thanks, Ziad, I think you make the point very well: the key is knowing *when* to be aggressive in execution--


Smoove D said...

Interesting. However, I think I'm missing a key piece of information. If institutions on average only make 1.5% per year after trading costs, why bother? They could do better stuffing the money in a bank account.

Lance said...

"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."

As I read the paper, the retail investors made money in the short term on limit orders and lost money on market orders. Most limit orders are below the market. That's why you used to see the top stocks on the Ameritrade index were all stocks down on the day. Aggressive orders does not mean buying strength, it means placing market orders. Did you actually read the paper before providing your moralizing commentary? Oh those greedy and stupid retail investors, always buying strength! Actually, it's the opposite.

Brett Steenbarger, Ph.D. said...

Hi SmooveD,

Yes, I think you're pointing to something important: institutions overall don't necessarily beat the market or earn excess returns. It's also a subset of those that are truly successful in the marketplace.


Brett Steenbarger, Ph.D. said...

Sorry, Lance; I may have been unclear. Market orders imply buying strength (lifting offers) and selling weakness (hitting bids). It's a form of being aggressive, rather than working resting orders below the market (to buy) or above the market (to sell).


Nolan said...

If I place entry orders in anticipation of a price movement through my entry, does that make me just as patient and passive as the person waiting to catch a reversal. I'm not sure we can infer that waiting to catch a reversal is the only 'successful' passive strategy. The article seems to leave it more open ended than that.

MikeH said...

Point should be noted that the Taiwan market is not continuously matched, matched once or twice every 90 seconds. That being said, every floor trader I talked to back in the 90's would never give up the edge of the spread. A similar study is out there somewhere stating something to the nature that 80% of forex dealers profits comes from the spread (this was before the advent of retail forex). The concepts really have not changed, only the implementation. As a retail trader, you are up against two powerful opponents - liquidity providers and commercials. Hard to imagine you are going to beat them in balanced market conditions.