Active Trading: Speculative Animal Spirits on the Rise

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Vince Lombardi once said, “Winning is a habit. Unfortunately, so is losing.” One thing is for sure: day traders have a habit of losing. Like a hamster on a spinning wheel, day traders spend a lot of energy creating loads of activity, but end up getting nowhere in the process. This subject is important because the animal — or, hamster — spirits are on the rise as evidenced by the 22 percent and 17 percent increase in average client trades per day reported last month by TD Ameritrade (NYSE:AMTD) and Charles Schwab (NYSE:SCHW), respectively.

The statistics speak for themselves, and the numbers are not pretty. An often cited study by Terrence Odeon (U.C. Berkely) and Brad Barber (U.C. Davis) showed that 80 percent of active traders lose money. The duo came to this conclusion over six years of research by studying 66,465 accounts. More importantly, they “found that if you were to look at the past performance of these traders, only 1 percent of them could be called predictably profitable.” Ugh!

How can this horrendous performance be true? Especially when we are continually bombarded with the endless commercials of talking babies and perpetual software bells and whistles that shamelessly promote a simple path to prosperity. The answer to why active trading fails for the overwhelming masses is the following:

  • Taxes/capital gains
  • Transactions costs/commissions
  • Research costs/software
  • Lack of institutional advantages (speed, beneficial rates, I.T./automation, execution, etc.)
  • Impact costs (buying handicaps returns by pushing purchase prices higher, and selling handicaps returns by pushing sale prices lower)
  • Absence from participation in long-term upward drift in equity prices

After considering the horrible odds stacked against the active trader, the atrocious results are not surprising.

The Blemished Investing Brain

So far, we’ve discussed the mechanics behind the money-losing results of active trading, but the underlying reasons can be further explained by the three-pound, 100,000,000,000 amalgamation of cells located between our ears. Evolution has formed our brains to seek pleasure and avoid pain, and trading stocks can create a rush like no other activity. Similar to the orgasmic emotions triggered by making a quick buck at the blackjack table in Las Vegas or scratching off a winning number on a lottery ticket, buying and selling stocks creates comparable effects.

Through the use of high-powered, multi-million imaging technology (i.e. functional MRI), Brian Knutson — a professor of neuroscience and psychology at Stanford University — discovered that active trading for money impacts the brain in a similar fashion as do sex and drugs. The data is pretty compelling, because you can see the pleasure center images of the brain light up dynamically in real time.

To put the results of his human trading experiments in context, Knutson noted that, “We very quickly found out that nothing had an effect on people like money — not naked bodies, not corpses. It got people riled up. Like food provides motivation for dogs, money provides it for people.” Brokerage firms and casinos have figured out the greed-seeking weakness in human brains and exploited this vulnerability to the maximum. By rigging the system in their favor, mega-billion dollar financial institutions and gaming empires continue to crop up around the globe.

The emotional high experienced by day traders is one explanation for the excessive trading, but there is another contributing factor. The inherent human cognitive bias that behavioral finance academics call overconfidence (or illusory superiority) helps fuel the destructive behavior. Surveys that ask people if they are above-average drivers highlight the overconfidence phenomenon by showing the mathematical impossibility of having 93 percent of a population as above-average drivers. Similarly, a study of Stanford MBA students showed 87 percent of the respondents rating their academic performance above median.

Even Jesse Livermore – arguably the greatest trader of all time — realized the negative impacts of emotions and active trading when he said, “It was never my thinking that made big money for me. It always was my sitting.” As I’ve written in the past, active trading is hazardous to your long-term wealth. Rather than succumbing to the endless pitfalls of day trading and getting nowhere like a hamster on a spinning wheel, it’s better to use a long-term, objective, and unemotional investing process to achieve investment success.

Wade Slome, CFA CFP is President and Founder of Sidoxia Capital Management and shares his investing insights at Investing Caffeine.

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