The Illogic of Active Trading – My Take

While we don’t know exactly why people are trading, Joe Kinahan, chief strategist at TD Ameritrade, made it pretty clear in an earlier news release: “Our clients have been dialing up equity market exposure and participating in the rally every step of the way.” In addition to all this trading activity, many of the online brokerage firms are seeing cash levels at their lowest point in years.

But wait! Isn’t trading bad?

We’ve known trading is bad for a very long time. A series of academic studies done by Terrance Odean and Brad Barber found conclusively that investors who trade a lot experience reduced returns. In fact, the more they trade the worse their return is likely to be. Based on the activity we’re seeing today, it’s worth noting what Mr. Barber and Mr. Odean wrote in 2000: “It is difficult to reconcile the volume of trading observed in equity markets with the trading needs of rational investors.”

So why are people doing it?

After the best year we have seen from the markets in more than 15 years, a rise from the panic-inducing levels of 2009 and in the face of pretty conclusive evidence that trading leads to lower returns, why are we trading more?

Source: The Illogic of Active Trading – NYTimes.com

Above is a section of the referenced New York Times article addressing a recent increase in trading activity. The problem, according to the article, is that there is conclusive evidence that more frequent trading leads to lower returns. This is something that I sort of believe, but my reasoning behind it has changed over the last few months, in large part to the new paradigm of investing that I am learning from tastytrade.

The tastytrade people put out an excellent educational, analytical, and funny show that I have been watching in breaks between studying. On April 29th, tastytrade interviewed Carl Richards, the author of the NY Times article. The video is below:

tastytrade believes that “the more active you, the more successful you are.”

I actually agree with both Tom and Carl in the video. However, I think both are arguing for slightly different things.

Carl’s definition of “active trading” is when the average investor buys and sells based on current market conditions or on the advice of a “guru” on one of the financial shows. Those investors are the ones that hear from their buddies that the stock market is hot and start investing near the peak and then sell when things turn sour, like after the tech crash in early-2000s or in 2008.

What these investors are doing (buying high and selling low) is the exact opposite of what you would want to do in the perfect world. Their behavior, not the instrument, is the problem. You’d be far ahead by simply holding on to the companies or even solely investing in cheap index funds. Invest in companies that raise the dividend yearly and a temporary unrealized loss actually isn’t that bad since the dividends start to compound after awhile.

Tom’s definition of “active trading” is increasing the number of high probability occurrences. He argues that with the technology available today you should be able to outperform the index funds. And I agree. I love learning about this stuff.

In fact, if I won $1000 today, I’d immediately transfer it into my brokerage account. Sure, there’s stuff that I could buy, but I actually get enjoyment out of the investing. It isn’t a hassle to have to set aside a certain amount of money each month to make sure my retirement gets funded. Personally, I’d rather trade with and invest that money than buy a new TV.

And if things go as planned, I might be able to turn that $1000 into something much more.

I am taking advantage of the opportunities that Tom discusses and trying to get as educated as I can. However, as “simple” as they are making it, it still does take work. All the statistics show that Americans in general are spending too much and saving too little. We love researching our fantasy football, as Tom says, but don’t spend nearly enough time with financial literacy.

Rather than add any complexity, my argument is that people should just start doing something. Anything. Those of us that follow the advice of Tom and tastytrade will likely do great financially. But, those that invest in low-cost index funds will do fine too. Anything is better than actively moving in and out of the market (likely at the wrong time) or sitting in cash or CDs your entire life.

Tom says that the market has historically returned just over 6% a year. Carl responds by saying that the average investor has not even gotten that return because of the buying high and selling low behavior described above. It seems that the disconnect between the two is based on what is deemed an adequate percent increase per year.

Carl is happy with being par, but Tom knows that he can do so much better.

It’s a great discussion. I’d love to hear from Carl again after he has a chance to sit down and talk with the tastytrade team. I hope they have him back on!

One thing to keep in mind is that while I love talking and learning about this stuff, most people don’t have any desire to really spend the time to do it. For likely the vast majority of Americans, just starting a savings plan, reducing debt, and then maybe getting their feet wet with some investing is a great goal.

Keeping it as simple as possible is the only way for them to succeed. Hitting par to achieve that historical annualized result is a huge start and one in which they are more likely to be successful than asking them to watch some options trading videos or read investing books.