"In aggregate, day trading is a losing proposition; day trading is an industry that consistently and reliably loses money. From an industrial organization perspective, it is difficult to understand how such an industry survives.
-- "Do Day Traders Rationally Learn About Their Ability," Barber, Lee, Liu, and Odean
Now, we can all sit here and poke fun at the idea that day trading is a terrible idea. And, trust me, there's definitely a time and a place for that. But even though it focuses specifically on day traders, I think this behavioral finance research paper holds an important lesson for us investors.
But first, let's take a look at just what this quartet of researchers uncovered. First, they found that there is some basis for saying that traders act rationally. Specifically:
- Unsuccessful traders were more likely to quit day trading.
- Traders tended to start off with small positions and increased those positions after trading successfully.
But -- maybe not surprisingly -- rationality did not rule the day. The researchers also noted that:
- Aggregate trading performance was negative, so it is basically irrational for anyone to take up day trading in the first place.
- Though unprofitable day traders are more likely to quit, they don't automatically quit -- and many hold on remarkably long. The researchers highlighted that in the data set they examined "unprofitable day traders represent nearly a quarter of the day trading population, but represent over half of all day trading activity. Thus, many day traders are remarkably persistent in their day trading activity despite a history of losses and do not appear to be rationally learning about their ability."
Frankly, being a Vegas resident, this isn't all that shocking to me. On any given day of the week you can find the casinos chock-full of patsies stuffing cash into slot machines that are programmed to provide a negative return. That some folks do the same with the stock market doesn't strike me as breaking news.
Staying rational
So how do we avoid the irrational fate of the day traders? A solid start is an awareness of our propensity for irrationality when it comes to financial decisions. Past that, we could take the simple step of keeping track of our performance and -- if we are consistently unsuccessful in our efforts -- being ready to take the step that many day traders seemed unable to take. That is, of course, quitting.
Despite what the efficient-market proponents might tell you, there are many good reasons for investors to take matters into their own hands. However, if the results aren't there, then there are some very good alternatives, such as investing in the entire market through indexes.
Setting the bar
If we're going to evaluate our own performance, a good place to start is by defining exactly what success is. Not consistently losing money seemed to be enough for the "successful" day traders in the study -- and if that's your goal as an investor, you may want to just consider index funds now.
Here are a few possible measures of success for an investor:
- Beat the S&P 500. Simple and straightforward: You want to report returns that are better than the S&P 500 index. In this case you can adopt a number of different strategies, including looking for companies like Cirrus Logic (Nasdaq: CRUS) that have high expected growth rates, or stocks like Hewlett-Packard (NYSE: HPQ), which are trading at multiples well below the market average.
- Cut the risk. While this strategy may be tougher to appreciate from a headline perspective, achieving your returns with less risk than the overall market can be a very worthwhile strategy. Stocks like Johnson & Johnson (NYSE: JNJ) and Procter & Gamble (NYSE: PG) may not be your ticket to huge home runs, but buying stable, reliable stocks like these at prices that could bring market-matching returns could be chalked up as a definite success.
- Crank up the income. The S&P 500 has a pretty pathetic dividend rate, so investors with a thirst for current income could focus in on stocks like AT&T (NYSE: T) or National Grid (NYSE: NGG). Consistently maintaining a current payout above the rest of the market could likewise be considered a plus.
There are certainly other possibilities as well. But the key is to clearly define for yourself what investing success means to you. Don't say, "Oh I have a general idea." Don't just think about it a little. Take a moment to settle on why it is you're bothering to spend the time and effort to invest in the first place, and then write that down somewhere so that you can refer back to it later.
That wasn't so hard, was it?
Now that you've defined success, the next task is to track your performance over time and determine whether you're actually able to meet your goals. So, for instance, if your goal is to beat the S&P 500's returns, your tracking would simply involve keeping tabs on your performance and the performance of the S&P 500.
The right kind of smarts
While the folks at Goldman Sachs and other Wall Street firms wear suits and have Ivy League degrees, being a rational investor may be a heck of a lot more important than being a brilliant investor. But don't take my word for it -- here's what Warren Buffett has had to say on the subject:
If you are in the investment business and have an IQ of 150, sell 30 points to someone else. ... It's not a complicated game. It's simple, but it's not easy. You have to have an emotional stability.
Ready to get to work rationally testing whether you can deliver on the investment front? A good place to start is with this special report from my fellow Fools, "13 High-Yielding Stocks to Buy Today." You can get a free copy by clicking here.
