Believe it or not, this myth persists. A few friends tell me they make money day trading – even through the Great Recession. One might assume a good day trader would keep his or her techniques secret. Not so; they are prone to brag. (That may be a clue about this myth.) It is so easy to shift money quickly with no middleman, they argue. The explosion of online trading companies adds fuel to the day trader fire. In fact, a number of studies show that most day traders do not fare well. But in the face of this persistent myth, our task is to look beyond the obvious and to deal with the props of the day trading mystique.
Three powerful arguments expose this idea as false. Market volatility is massive these days. Note that volatility means sudden, unpredictable rises and falls. The market has always seen undulations, but the last few years have seen faster turnarounds.
Here is the problem for day traders: how does one predict volatility and take advantage of it? Most investors try to avoid volatility, shifting their money into safer or at least less volatile alternatives. Gold and art do very well thanks in large measure to volatility. But day traders appear to welcome volatility; it offers an opportunity to make a bundle – at least when stocks are on the upswing. But again, how does one really make this happen?
A slow rise or fall of one stock or even a whole industry can be seen and acted on. For example, after Warren Buffett bought Burlington Northern, investors reacted by asking “Why?” Then all railroad stocks rose. Slowly the market got on the train (pardon the pun) and made money along with Buffett. But not all stocks or industries rise or fall in lockstep. After the British Petroleum (BP) oil spill in the Gulf, oil stocks slipped. They all recovered after a time; BP did lag its competitors, however. So, an investor might have bought when the oil stocks were down, believing that they would come back. That is a well known investment axiom. It doesn’t take a day trader to make this kind of investment decision. And, if we are to hold a day trader’s feet to the fire, none of this happened in a day. Several months were involved. These opportunities actually do not fit the tremendous volatility of the last few years.
The problem is seeing and capitalizing on volatility in such a short time frame. Gold, the presumed hedge (also a subject of a myth busting piece), may move opposite to the market. But, gold has not been a consistent hedge in recent months. Even when it lives up to its hedge image, one has to see the whole market moving down to capitalize on gold’s counter movement. Then when things turn the other way – stocks rising, gold falling — the day trader would have to move quickly in the opposite direction – dumping gold for rising stock. This movement is also unpredictable. Recent volatility finds sharp declines for days, even weeks. The peak and valley are hard to see. So the day trader faces several nearly insurmountable tasks — seeing and acting on sudden rises and falls. And the day trader must see one investment falling and another rising.
The second argument concerns smart money shifting to more attractive investment options. A New York Times page one article (Feb. 19, 2012) shows that mortgage-backed securities are regaining popularity. “Who’d a thunk?” as Mortimer Snerd asked. For the last few years, investors have been moving in and out of stocks, US and foreign, bonds, gold, etc. Here’s the difference with day trading: these shifts are not short-term. Investors may wait months, even years, trying to earn a reasonable return. Would you invest in a mortgage-backed security now?
All investors are cautious. It used to be that most investment companies strove to “beat the market,” eeking out even a fraction of an advantage over the Dow. Recent investment advertising stresses issues of trust and care. No one is talking about great returns! Rounded off, the market hit its low point in March, 2009 (6,600) and reached its Mt. Everest in February, 2012 (11,800). That is a 79% return – earned the hard way – and it took three years.
The third and most obvious argument is that day trading violates the time honored principles of buy and hold and portfolio theory. The market tends to move upward over time, sometimes in unpredictable spurts. Some investments offer superb returns with risk; others are much safer with only modest gains. A portfolio spreads risk by selecting many attractive, but admittedly unpredictable stocks and balancing them with safer alternatives.
By definition, wouldn’t a day trader have to put all of his or her eggs in one basket? If so, all of the wisdom of spreading risk and return and being patient disappears. Also, if the market falls for a period of time, which it has been prone to do for several years, would a day trader switch to cash? Well, they say cash is king. Maybe so, for day traders.
Please send suggestions for more myth busting efforts. Let’s agree there are more myths forming out there.
Michael McTague, Ph.D. is Senior Vice President at Able Global Partners, a financial consulting firm in New York City.