Track Record

Are Day Traders Trading One Evil for Another?

Track Record

Are individual investors really making a change when they transfer funds from Fidelity Magellan to an online discount broker?

Probably not as much as they think. Both strategies involve costs of one sort or another, and generally both involve high portfolio turnover. These are the top indicators of poor performance over time.

Day trading is without question on the rise. Stock trading over the Internet that circumvented traditional brokerages climbed 30 to 35 percent in the first three months of the year, according to Credit Suisse First Boston. This is the second straight quarter of 30% growth in Internet brokerage activity. More than one out of seven stock trades takes place over the Internet.

At the same time stock fund inflows are slowing. This is despite large amounts of capital accumulating in money market and other non-equity funds. Monthly inflows into US stock funds in the 12 months ending this March fell to $132 Billion from $217 Billion the year before, according to Eric Bjorgen at Leuthold/Weeden Research. There is no major demographic or economic phenomenon that would explain the slowdown in inflows. One sensible explanation is that investors are punishing actively managed funds for performing poorly (Q1 99 gains for diversified US stock funds were an anemic .93%, according to Lipper), as well as for consistently lagging the most widely followed index, the S&P.

A substantial amount of day trader assets no doubt are coming from active fund assets, or at least from assets that would otherwise been channeled into active funds.

Is this a smart move by the investor? Day traders have done well in this market of expanding multiples, to be sure. Many did so by focusing on big names and technology issues, which returned the favor by blasting into the stratosphere. Internet stocks are the extreme example of a pool of stocks bid up by day traders but missed by most fund managers.

Unfortunately with day trading, investors may be replacing one evil for another. Even at $10 a trade, transaction costs grow commensurately with turnover. Small accounts are hit especially hard as they cannot benefit from economies of scale. It is a mathematical axiom that the average investor paying high transaction fees to invest is going to underperform the average investor in the same market who is paying low fees.

There seems to be a growing desire to control one's own destiny. It is hard to argue with that. The curious part is that day traders generally view the mutual fund managers they fired as better qualified to pick stocks than them. Still they prefer to take the reigns and make the picks themselves. Their instinct for basic control over their financial future and their confidence in the ability to manage it is commendable.

But there is overwhelming evidence to suggest that high turnover and high transaction costs make it very difficult to outpace a passive portfolio of similarly classified assets. After tax the effect is even more pronounced. Wise asset class selection and perhaps a bit of speculative luck may have emboldened the day trader so far, but if reversion to the mean holds true then day trading may become a less glamorous occupation in coming months and years.

The most disturbing thing about day trading is the opportunity cost. History shows that stock picking of any kind is a low return exercise, and many day traders are clever professionals who could be earning large salaries in more productive activity.

There is of course a social dimension to this issue. What civic duties and family activities could the day trader have engaged in instead of the futile search for extraordinary returns based on ordinary information and skill?