Why Many Day Traders Will Fail (NYSEARCA:SPY)

Why Many Day Traders Will Fail (NYSEARCA:SPY)

Summary

Academic research illustrates that the equity risk premium has been attributable to only a small number of stocks.

While average returns are positive across markets, median returns for U.S. and global stocks trail the risk-free rate. Positively skewed strong performers tilt the market returns decidedly positive.



This article discusses the similarities and differences through a gambling metaphor that shares similar probability of besting a risk-free option.

The combination of government stimulus checks, the evolution to ultra low or zero cost trading, and ample free time during market hours has been a recipe for record levels of brokerage account openings. Robinhood, a provider of commission-free investing, has seen accounts rise 30% to 13 million in 2020. In general, I applaud the democratization of finance that has led more households into the stock market. As barriers to entry and costs have fallen, a new wave of market participants has entered the fray. The median age of a Robinhood customer is just 31 years old.

The last three months have been a great time for speculation. Volatility has been historically elevated. The market experienced an historically rapid market drawdown in February and March, but rebounded with an equally historic rally. These types of moves – both on the downside and subsequent upside – had not been seen since the Great Depression. For investors catching the upswing of markets, it feels like the stock market game is easy. These new investors may not understand that they have caught an updraft the likes of which none of us have experienced before.

For those picking stocks for the first time, it can be thrilling to see account balances grow. Most novice investors understand that stocks have delivered strong long-term returns (roughly 10% annualized in the United States for the past century). A bet on a speculative stock today may come with the hope of catching lightning in a bottle to generate short-term gains, but the expectation that rising stock markets over time can boost bets that don’t pay off quickly.

Robintrack, an unaffiliated site leveraging the Robinhood API data, tracks the number of Robinhood users who hold a particular stock over time. The current top dozen most commonly owned companies, feature two airlines – American Air Lines (AAL) and Delta (DAL), two cruise line companies – Carnival (CCL) and Norwegian (NCLH), a cannabis company (ACB), and a fuel cell company that has never turned an annual profit in its twenty year operating history, Plug Power (PLUG). This ownership group signals that these new investors are speculating on stories they hope offer asymmetric upside.

A little historical perspective might help frame the bet investors are making on stocks. In 2017, Arizona State professor Henrick Bessembinder authored “Do Stocks Outperform Treasury Bills?” Even new investors know that the simple answer to the titular question is a resounding “yes.” Over long time intervals, the equity market has, on average, paid an investor a premium for taking equity risk.

In tracking nearly 26,000 stocks, Bessembinder found that a whopping 58% of stocks failed to outperform Treasury bills over their lifetimes in a long-term dataset, stretching back to 1926. On average, stocks outperform over long time intervals, but the median stock in the U.S. equity market has actually produced negative alpha, an average return that trailed risk-free Treasury bills. This is a stat that should be of great interest to day traders out there.

For context, for those more prone to gambling in stocks markets rather than investing, the odds of winning a single hand of Blackjack (or Twenty-One globally) are around 42%. The odds of picking a stock that beats the performance of Treasury bills over its life and winning a hand of Blackjack are roughly equal. Just like a gambler can buck the odds and go on a great run at the card table, bootstrapping single stock picks into long-run success is a difficult to replicate feat for many. Investing is a better game than Blackjack. The “house” does not have “odds” if you spread your bets wide enough, and the average return is positive. It is important to know that the return of a single bet is lower than the riskless option (short-term Treasuries) just as the average returns of a single hand of Blackjack is lower than the riskless option (not playing).

Much of that Bessembinder paper focused on the fact that while the equity market generates above-average returns on average, the fact that the median stock failed to generate a return above T-bills was a function of positive skewness in the cross-sectional distribution of stock returns.

That is a big thought, so let’s break it down with an example. Imagine a stock that goes up by 30% or down by 30% with equal probability in a given period. Markets just witnessed a 30% drawdown in February, and a greater than 30% subsequent rally, so this is a salient example to those recently entering the market. The arithmetic mean return of down 30% and up 30% is zero. In a two-period scenario, there are four potential outcomes:

In this example, the average return is zero, but the median return in negative. There is a three-in-four chance that you are going to generate a negative return, but the large return in the bull case offsets the negative cases. That is positive skewness, and the idea behind why the stock market has generated long-run excess returns, but most stocks have not produced a better return than bonds.

It makes intuitive sense. Over very long-time intervals, the maximum you are going to lose is 100%, but cumulative gains can be astronomical. The right tail of the distribution is much longer. Unfortunately, the most common cumulative return over a decade long holding period for stocks in the database is -100%. The modal return for day traders will also be -100%. The positive excess returns for the market are a function of that long right tail.

I am encouraged to see more participants in the stock market. While speculation can be sporting, new traders should be working to gain new skills and developing a longer-term investment plan that fits their risk tolerance and investment horizon. For those that liken investing to gambling, history shows that a single stock pick has no better odds of beating a riskless option than a hand of blackjack. If the stock market is a casino, it is one where the average return is positive, as long as the bets are spread widely enough to capture the return skew in markets. Let’s look to seek this alpha together.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance and investment horizon.

Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


Originally published on Seeking Alpha

S&P 500 
$3,130.01  (0.45%)
NASDAQ 100 
$10,341.89  (0.61%)
Dow Jones Industrial Average 
$25,827.36  (0.36%)
Apple Inc. 
$364.11  (0.00%)
Alphabet Inc. 
$1,464.70  (1.85%)
MICROSOFT CORP 
183,42 €  (-0.08%)
Tesla, Inc. 
$1,208.66  (7.95%)
Berkshire Hathaway Inc. 
$267,551.00  (0.20%)
AbbVie Inc. 
$98.88  (-0.26%)
Costco Wholesale Corporation 
$305.74  (0.32%)
Smartsheet Inc. 
$52.70  (-2.15%)
Zai Lab Limited 
$81.10  (1.76%)
Western Digital Corporation 
$42.44  (-0.02%)
NVIDIA Corporation 
$384.49  (0.86%)
Gold Aug 20 
$1,787.30  (-0.15%)
Crude Oil Aug 20 
$40.32  (-0.81%)
BTC/USD 
$9,060.73  (-0.69%)
Bitcoin Cash USD 
$220.42  (-0.79%)
LTC/USD 
$41.11  (-0.92%)
ETH/USD 
$225.01  (-1.91%)
Dogecoin USD 
$0.0023  (-2.11%)