Most day traders, especially heavy day traders, lose money trading. Why do investors engage in such a wealth reducing activity?

Question: 

There are more than 100 million people in the world engaging in trading everyday.
If trading do not work, why would there be so many people engaging in this activities everyday over long period of time?

WHY? I am puzzled too.


Most day traders, especially heavy day traders, lose money trading. 
Why do investors engage in such a wealth reducing activity?

1. One possibility is that investors simply find day trading entertaining.
- Undoubtedly some investors do find day trading entertaining, but can entertainment account for the extent of day trading that we observe? 
- Do day traders knowingly and willingly accept such large expected losses for fun? 
- For all but the wealthiest investors, this would be a very expensive form of entertainment indeed.


2. Another reason why day trading might entice investors would be if it provided an appealing distribution of returns. 
- People often display an attraction to highly skewed investments, such as lotteries, that have negative expected returns but a small probability of a large payoff. 
- However, the day trading profits that we document are similar in magnitude to, and far less prevalent than, losses. 
- Unlike lottery winners, day traders must succeed on repeated gambles in order to achieve overall success. 
- Such repeated gambles do not tend to generate highly skewed distributions.


3. A final potential explanation for the prevalence of day trading is that most day traders are overconfident about their own chances of success. 
- Several papers (e.g., Odean (1998, 1999), Barber and Odean (2000, 2001)) argue that overconfidence causes investors to trade more than is in their own best interest. 
- Overconfident day traders may simply be bearing losses that they did not anticipate. 
- While day traders undoubtedly realize that other day traders lose money, stories of successful day traders may circulate in non-representative proportions, thus giving the impression that success is more frequent that it is. 
- Heavy day traders, who earn gross profits but net losses, may not fully consider trading costs when assessing their own ability. 
- And, individual day traders may believe themselves more likely to succeed than the average day trader. 
- We are unable to explicitly test whether day traders are motivated by overconfidence rather than the desire for entertainment. 
- Our opinion is that the average losses incurred by day traders are more than most would willingly accept as the cost of entertainment and that, by and large, day traders must hold unrealistic beliefs about their chances of success.

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The Growth Stocks of Peter Lynch

Peter Lynch 

From 1977 through his retirement in 1990, Peter Lynch steered the Fidelity Magellan Fund to a total return of 2,510%, or five times the approximate 500% return of the Standard & Poor's 500 index. In his 1989 book One Up on Wall Street, Lynch described a variety of strategies that individual investors can use to duplicate his success. These strategies divide attractive stocks into different categories, each characterized by different criteria. Among those most easy to identify using quantitative research are fast growers, slow growers and stalwarts, with special criteria applied to cyclical and financial stocks. (The latter, for example, should have strong equity-to-assets ratios as a measure of financial solvency.) 

Peter Lynch's Company Categories: 

Fast Growers 

These companies have little debt, are growing earnings at 20% to 50% a year, and have a stock price-to-earnings ratio below the company's earnings growth rate.

Investing in these types of stocks makes sense for investors who want to findsolidly financed, fast-growing companies at reasonable prices. 

Slow Growers 

Here Lynch is looking for companies with high dividend payouts, since dividends are the main reason for investing in slow-growth companies.

Among other things, he also requires that such companies have sales in excess of $1 billion, sales that generally are growing faster than inventories, a low yield-adjusted price/earnings-to-growth ratio, and a reasonable debt-to-equity ratio.

Investing in these types of stocks makes sense for income-oriented investors. 

Stalwarts 

Stalwarts have only moderate earnings growth but hold the potential for 30%-to-50% stock price gains over a two-year period if they can be purchased at attractive prices. 

Characteristics include positive earnings; a debt to equity ratio of .33 or less;sales rates that generally are increasing in line with, or ahead of, inventories;and a low yield-adjusted price/earnings-to-growth ratio. 

Investing in these types of stocks makes sense for investors who aren't willing to pay up for high-growth companies but still want the chance to enjoy significant capital gains.

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Banks lead the equity sector flows

Banks and financials stocks have had a pretty good year. The Thomson Reuters Global Financials index is up by more than 20% in the last 12 months, and although the detritus of the financial crisis still offers the occasional sting, investors are starting to see brighter spots for the industry.

That confidence is increasingly obvious in the fund flows.

Our corporate cousins at Lipper track more than 7,000 mutual funds and ETFs which are dedicated to specific industry sectors. Dig a little into the data in this subset of funds, and you start to get a pretty good picture of where the biggest bets have been placed.

Just shy of 500 of these funds are focused entirely on banks & financials. Together they hold more than $46 billion in assets.

Last month, they suffered a total net outflow of just about $1 billion, but on a one-year view, 10 months of net inflows have driven an injection of over $10 billion. It amounts to a concerted bet on the sector, particularly in the U.S. where the bulk of assets are held, with the inflows equating to 22% of the latest published assets under management. You can see the evolution over the year in the chart below; cumulative gains or losses over the 12 months are shown in the blue area; monthly flows are shown by the red bars.

The sector was by far the most popular, both in absolute terms and relative to the assets held.

Cyclical consumer goods and services funds (chart below) managed a net inflow equivalent to about 18 % of their latest published assets over the 12 months, while biotech funds andpharma/healthcare funds were at 15% and 10% respectively. Pharma/healthcare was in second spot in absolute terms, with a 12 month net inflow of $7.8 billion, while global real estate (chart below) was third with $5.6 billion.

Worth noting too that the global real estate sector was the most consistent over the year, pulling in overall net inflows in 11 out of the 12 months, according to Lipper’s estimates.

Get in touch with me directly at joel.dimmock@thomsonreuters.com or on Twitter if you’re interested in seeing the full data.

Outside the big ticket numbers, there’s a tale to tell among the information technology funds.

Over 12 months, they have only managed net inflows equivalent to 1.6 % of assets – well below the average for all 20 sectors, according to the Lipper estimates, but the last four months have been marked by a resurgence. The funds posted overall net inflows of more than $1.2 billion in both May and July – the biggest monthly results since the beginning of 2011 and a turnaround which hauled the sector back into the black for the year. Check out the chart below.

Of course, equities are enjoying a long summer and a rising tide lifts all boats – or at least it tries to. Some sectors are still under water, and telecoms services equity funds take the wooden spoon, posting net outflows over the 12 months equal to 13% of assets and suffering 10 down months in the process.

And finally, it will surprise no one that gold and precious metals equity funds have seen one of the sharpest reversals, but it’s noticeable that it pivoted on a $1.4 billion net outflow in January as investors, pretty successfully it seems, anticipated an about 20% fall in the gold price since then.

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US investors prop up emerging equity flows

U.S. mutual fund investors are ploughing on with bets on emerging market equities, according to the latest net flows numbers from our corporate cousins at fund research firm Lipper. Has no one told them there’s supposed to be a massive sell-off?

August was the 30th straight month the sector has seen net inflows, and the 9th straight month of net inflows above $1 billion. Sure, there’s a downward trend from the February peak, but the resilience of demand is notable given doom-laden headlines about how EM markets will fareonce the Fed feels its generosity is no longer required.

Of course, the popular image of mutual fund investors is as a perennial lagging indicator for allocations trends, and the stage may be being set for a sharp turnaround this month. However, U.S. investors have already been offloading their bets on emerging debt, with funds in the sector seeing net outflows of $2.6 billion, or 7.5% of total assets, in the three months to end-August.

It may be that this is part of a trend towards international diversification in the U.S., with investors taking a longer view and a more sanguine approach to risk. But they’ll need strong stomachs. Three-month performance at those U.S.-domiciled EM equity funds is at -7.7% (see chart below), while three-month net inflows are at more than $4.5 billion. Juxtapose that with the global EM equity sector over the same period, where  average fund performance is at -8.2% and net outflows are a chunky $7.8 billion. In short, investors elsewhere are pulling cash out of emerging equity funds but U.S. fund buyers seem to be going the other way.

Chad Cleaver and Howard Schwab, emerging markets fund managers at U.S. fund firm Driehaus Capital, reckon the data simply reflects  some clear incentives for American investors to stick with EM. They told us:

Firstly, profits from the US equity market can be redistributed into cheaper/lesser performing asset classes. Secondly, US investors/institutions have an unreasonably high percent of money in bonds. A reallocation of bonds assets, even in a small part, can create flows for emerging market equities.

Lastly, US investors are reasonably more positive/confident in global growth… and hence identify the cyclicality of emerging markets as an eventual beneficiary of this phenomenon.

They also highlight that lure of real diversification as we move away (investors hope!) from a risk-on, risk-off world.

While the composition of emerging markets may change… the overall opportunity within emerging markets remains highly differentiated from the economic/company fundamentals of more developed countries.

It may also be instructive that many of the U.S. mutual funds showing the strongest inflows are actually targeted at institutions. As developing nations’ stock markets are hammered by fears over the impact of Fed tapering, so major investors with emerging markets allocations targets to maintain will be engaged in a race to top up their holdings.

With this in mind, it’s useful to note that thanks to tumbling markets the total assets of the U.S.-based EM equity funds which have published August data have still fallen month-on-month, despite the net inflows. This cohort of funds have seen total AuM fall from $115 billion at end-July, to $113 billion at end-August, proving that even diversification, growth bets and allocation technicalities can’t keep a good downturn down.

(NOTE: Not all funds have published data for August as yet. The data from U.S. funds is based on about 150 funds out of 240 in total. The funds used represent about two thirds of the assets held across the whole sector. The Global EM funds data is drawn from about 800 funds vs a total sector made up of about 1,100 funds)

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100-Year Flood /= 100-Day Flood

Investors experienced a 100-year flood in 2008-2009 and now it seems a broad array of media outlets endlessly bombards us with new, impending 100-day floods that are expected to drown investment portfolios and wash the economy into recession. The -3% drop in the S&P 500 index during August is symptomatic of investor nervousness.

This is nothing new. The media has been reporting scary forecasts every day over the last four years. Yesterday, we heard about the flash crash, Dubai, debt ceiling debate, Greece, Cyprus, eurozone demise, presidential election uncertainty, fiscal cliff, Iranian nuclear threats, North Korean provocations, and other potentially deadly floods.

Today, the worrisome flood forecasts include Syria, bond tapering, rising interest rates, debt ceiling part II, Ben Bernanke’s Federal Reserve successor, sequestration part II, Egypt, mid-term Congressional elections, and other natural and artificial disasters.

Despite a tsunami of unrelenting worries, the fact remains that corporate profits are at record levels (see chart below), corporations are holding record levels of cash, and even with a weak performance by stocks in August, the market is still up +15% this year, only off all-time record highs.

Source: Calafia Beach Pundit

Notwithstanding the recent record levels, stock ownership is at 15-year lows (see Markets Soar and Investors Snore) and skepticism still reigns supreme. By the time the coast is clear, and confidence returns, the opportunities will be vastly diminished. For the overwhelming majority of Baby Boomers and younger retirees, the investing game will remain challenging.

Wear a Raincoat & Ignore Data

Rather than succumbing to fears arising from volatile data and gloomy predictions, it is better to grab an investment raincoat and ignore the data. Sticking to your long-term investment plan is paramount. Legendary investor Sir John Templeton encapsulated the relationship of emotions and stock prices perfectly when he stated, “Bull markets are born on pessimism and they grow on skepticism, mature on optimism, and die on euphoria.” Fellow investor extraordinaire Peter Lynch highlighted the irrelevance of tracking macroeconomic data by noting, “If you spend 13 minutes a year on economics, you’ve wasted 10 minutes.”

When describing investment success, Lynch went on to say, “Whatever method you use to pick stocks or stock mutual funds, your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed.”

We’ve all survived the 100-year flood of 2008-09 with our lives, but confidence has been beaten down with the subsequent list of scary, misplaced forecasted floods over the last four years. Patient, long-term investors have been handsomely rewarded, with approximately +150% returns in stocks from the lows, but ominous economic predictions will persist. While the next 100-year flood probably won’t be here for another generation, disastrous forecasts will continue. As I’ve pointed out earlier, there is no shortage of concerns. There is always something horrible going on in this world somewhere and there will always be something to worry about. Who knows, tomorrow could bring an earthquake, terrorist attack, Russian currency crisis, Iranian regime change, Zimbabwean hyperinflation, or some other unforeseen concern.

There will be plenty of economic thunderstorms and showers ahead, but hiding in inflation eroding cash, or attempting to time the market is a recipe for financial disaster. Volatility is here to stay, so that’s why it’s so important to have a disciplined investment plan in place. Creating a globally diversified portfolio, across numerous asset classes, to smoothen volatility in a manner that meets your time horizon and risk tolerance is critical. Do yourself a favor and have your grandchildren (not you) worry about the next 100-year flood…that way you can ignore the multitude of phantom, 100-day floods.

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