The wide range of trading decisions that cause price moves unrelated to business value includes: trading for identifiable economic reasons of the trader, such as portfolio “rebalancing”; selling shares to fund personal needs or desires, such as a child’s education or the remodeling of a kitchen; and, most notoriously of all, day trading for purposes of speculation and gambling. Let’s start with that one.
Day trading is usually not based on fundamental values but on momentum, sector rotation, and other technical tactics of the type ridiculed earlier. When trades are based on these things, they move prices. Those moves, having nothing to do with values, widen the gap between price and value. This exacerbates Mr. Market’s peaks and valleys and feeds irrational exuberance and irrational despair.
Day trading is thus among the worst developments capital markets have seen in their history for purposes of maintaining an orderly or sensible market, much less an efficient one.
Many day traders are probably perfectly rational people; many are not. Aberrations may get headlines, but some of the day trader stunts captured by the mainstream press warrant attention. The Atlanta day trader who gunned down nine people and then himself in the summer of 1999 after suffering staggering day trading losses is a glaring example. So too is the fun-loving 44-year-old family man who tookearly retirement with his wife and their $780,000 nest egg only to murder the money day trading and then attempt to murder his wife (he wound up in a South Carolina prison).
Hardly tales of high rationality, and the woeful tales of these hapless folks are not isolated examples or aberrations. A Senate committee held hearings on day trading in early 2000 accompanied by a blistering report cataloging its numerous plagues. The report focused on the industry that supports day trading and emphasized the need for greater industry riskdisclosure, licensing, and minimum financial requirements for traders. But it is also a brief against the sagacity of the pernicious practice.
The most compelling conclusions of the report are that 75% of day traders lose money and that a typical day trader has to generate gains of $110,000 a year just to breakeven after costs! That figure is breathtaking, but the idea is not new. Classic studies have shown that someone who tries to time the market and move in and out of it quickly to exploit its gyrations has to be right 70% of the time to profit. Do you know anybody who can perform that well consistently? Even the best hitters in baseball—say, Rod Carew, George Brett, and even Ted Williams—bat at most .400 (the equivalent of “being right” only 40% of the time).
An equally important—if slightly more benign—source of trader volatility is the practice of “rebalancing.” Ironically, this practice was promoted mainly by those who use modern portfolio theory and believe in market efficiency. Rebalancing goes something like this: If you start with ten stocks each bought for 10% of the total cost of your portfolio, some will rise in price and some will fall. The rebalancer says that after a year or another arbitrary interval, lookat the new pricing. Suppose five went up and five went down, both in proportion. Now your portfolio has five stocks constituting 75% of the holdings and five stocks constituting 25%. The rebalancer says you should shed some of those in the 75% group to reduce their role in the overall holdings.
This must rankamong the dumbest things people could do with investments, yet it is very prevalent. You end up selling the stocks that seem to be performing relatively well and keeping those which come up behind. Why would you do that?
It may be rational, but not because your portfolio is somehow out of balance. It makes sense to sell the good performers only if you examine the business fundamentals of the companies and decide that they no longer meet your requirements for holding them: the price exceeds the value by large amounts, there are clearly superior opportunities for wider price-value gaps, the economic characteristics have deteriorated, or management has changed hands for the worse.
The famed investor Gerald Loeb gave the opposite advice, which is not easy to follow in the best of circumstances, much less when contemporary advisers are telling you something else: “If you want to sell some of your stocks and not all, invariably go against your emotional inclinations and sell first the issues with losses, small profits, or none at all. Always get rid of the weakest and keep your best issues for last.”
Like Loeb, Peter Lynch regards the prevalent practice of rebalancing as backward, saying it is like gardening by watering the weeds and pulling the flowers. The beneficiaries of this backward gardening are not the investors or traders who do the rebalancing but their advisers—who generate fees from trading—and the U.S. federal and local treasuries—which get tax payments. Buffett put it best in asking whether it would have made sense for the Chicago Bulls to trade Michael Jordan on the grounds that he had become too important and valuable to the team.
Apart from the stupidity of trading the best picks, the strategy’s contribution to trader volatility is significant. When trades are made to rebalance a portfolio in this way, they are by definition trades unrelated to business value (other than fortuitously). The sale of stock that no longer “fits” a portfolio puts price change pressures on that stock. But that pressure, having nothing to do with actual or even perceived value in that stock, simply widens the price-value gulf.
Finally, plenty of people have turned to the stockmark et as a savings account. It is the place where they repose regular sums to build wealth for planned projects such as buying a home, paying for a child’s education, and enjoying retirement. It is also the place where money is stored and drawn on for unplanned funding needs, such as paying to remodel a kitchen, buying a sports utility vehicle, and taking trips to exotic vacation spots.
It is hard to quarrel with those who use the stockmark et as a way to build wealth for planned future needs such as home ownership, education, and retirement. These tend to be long-term goals that enable long-term investing, and so the stockmark et is a rational place to store some of that wealth.
It is far easier to rebuke the use of the stock market for more short-term-oriented expenditures. For one thing, there is extraordinary riskin stockmark et investing, especially over short periods of time. It is simply not a rational place to put resources that may be needed to fund ordinary needs such as home repair and ordinary desires such as recreation.
As to either form of using the stockmark et, however, the net effect on market efficiency is the same. Trading decisions are based on needs (or desires) rather than on the fundamental values of the stockbeing sold. That has the effect, again, of separating the resulting prices from the actual values.
As more Americans use the stockmark et for these purposes— as traders rather than as investors—EMT explains less market activity. And as The New York Times said when day trader mania took hold, America has gone from a nation of savers, to a nation of investors, to a nation of traders.
ECNs and discount on-line brokers facilitate trading, rebalancing, and savings via stocks. Although this positively reduces the costs of incremental trading, it has an offsetting negative effect of encouraging more trades. In the aggregate market, negative information volatility and a wilder Mr. Market ensue.
It is like Reaganomics for brokers, as people end up spending more in commissions under this lower pricing per trade because they trade more often. Charles Schwab, to give a representative example of this industry, reduced its average revenue per trade from $64.27 in 1997 to $45.55 two years later while increasing daily trading volume from 106,000 to 208,000 and growing.27 Schwab’s revenues soared; you know who paid.
Day trading funds on the horizon will make all these matters worse. Marrying low-cost trading, screen-based clearing, and the insatiable day trader appetite, a former commissioner of the SEC launched a company in mid-2000 called Folio(fn) to cater to the rebalancing and day trading set. It offers a fixed annual fee that is not only much lower than typical mutual fund fees but also lower than the average cost per trade Schwab and others charge. It uses a proprietary trading system to match customer trading orders in house, going to market twice a day with compiled customer orders to clear any imbalance. Touted as a way to help investors, this day trading fund will increase trader volatility.
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