Does Day Trading Add Up?

Let’s face it, Americans are about as patient as a four-year-old on a sugar high.  We want what we want, and we want it now – RIGHT NOW!  While this trait serves us well in some ways – fueling competition and innovation – it’s a bad, bad thing when it comes to managing our personal finances.

Unless we’ve done a truly terrible job with this blog, it should be clear that we believe thoughtful, committed, long-term investing is the best way to achieve one’s financial goals, including a secure and rewarding retirement.

Shockingly, not everyone agrees.  Millions of Americans continue to play the short game.  They jump in and out of various investments hoping to buy low, sell high and score big.  The most extreme practitioners of this “market timing” philosophy are the day traders.  They habitually buy and resell a stock in the same trading day (often within minutes) in an effort to profit off the price differential as the stock moves up or down in value.  Some day traders do this for a living; others dabble to supplement their income.

Day trading is one the Internet’s many problem children.  While people have always speculated on stocks, the web gave everyone access to the tools and information necessary to make rapid trades.  Day trading emerged during the dot.com bubble of the 1990’s when it seemed everybody had a friend who knew a dude who was supposedly riding the market wave to financial independence by flipping stocks on his home computer.

After falling off the radar for a decade or so, day trading has reemerged in recent years, perhaps as a result of the market turmoil of 2008-2009, which left some people thinking they could do at least as well as the pros.  That mentality is fed by the relentless marketing of training programs that suggest it’s possible to secure a financial future by flipping stocks. (Like this)

Day trading

Yeah… not really.  The overwhelming majority of day traders are unsuccessful.  A 2004 academic study based on data from the Taiwan stock exchange revealed that 80% of day traders lost money and only 1% were “predictably profitable.”  That figure is probably low in the opinion of some experts, who think it may be as high as 90%.

“[D]ay trading is one of the dumbest jobs there is,” wrote former Wall Street analyst Henry Blodgett. “[M]ost of the people who do it… would be far better off working at Burger King.”

So why is day trading still a thing?  Because it lights up the same pleasure centers in the brain that make gambling so addictive. Day trading offers constant stimulation and occasional rewards to thrill-seekers who have a sense of invulnerability. In other words, young men.  Seventy-five percent (75%) of day traders are men aged 25-45, according to Hersh Shefrin, a professor at the University of California, Davis, who studies financial behavior.

“Over-confidence and over-optimism appear to be severe among day traders,” Hersh noted in his book, Beyond Greed and Fear.

It’s no mystery why these cocksure guys usually end up struggling to pay the rent.  The reasons are obvious and offer lessons for all investors.

The first deadly pitfall is under-capitalization.  Day traders need a big stack of cash to cover their inevitable losses and an even bigger pile if they hope to generate decent profits.  SEC regulations require day traders to keep a minimum $25,000 in their brokerage accounts at all times.  But industry experts set the bar much higher, suggesting a minimum ante of 50-times monthly living expenses to insulate the baby trader from the inevitable mistakes and losses.  Ideally, this should be “risk capital,” money that can be lost without leaving the trader homeless.  Anyone even hoping to make a decent full-time living from trading -- a return of $50,000 to $125,000 per year – needs a minimum $250,000 in capital, says veteran trader Alton Hill.

Too many traders lack the self-discipline necessary to make decisions based on analysis rather than emotion, according to industry observers.  This can lead to deviation from a carefully crafted trading strategy or excessive trading, which is costly and unproductive.  It can also result in bad reactions to failed trades.  In a desperate bid to recoup the loss a frenzied trader may repeat the same mistake or make new ones.  You know, like that college buddy you took to Vegas?  The one who was sure the next hand or roll of the dice was gonna turn it all around?

Traders who do manage a modest profit on their trading often see those gains offset by the significant cost of doing business, including brokerage commissions, sophisticated trading and analysis software, and access to real-time market news and in-depth research.

That expensive research is useless if the trader doesn’t know how to leverage it. Successful day trading requires wide and deep knowledge of market dynamics – not just the fundamentals, but near-Jedi level understanding of its complex structure, rhythms and craziness.  Such mastery comes only with time and practice during which the trader is often hemorrhaging cash.

And here’s the topper: Whatever profit a day trader does scratch from his countless hours of eye-straining, headache-causing, stomach-churning work is taxed as ordinary income at rates ranging up to 39.6%.  When a long-term investor finally cashes out he will pay a maximum 20% on his capital gains.

Bottom line, day trading is a sucker’s bet. It entices with an intoxicating brew of visceral thrills and possible wealth.  It delivers on the thrills, for sure, but seldom on the wealth.

For serious wealth building, long-term investing is unquestionably the way to go.  Setting financial goals, creating a budget, establishing an investment plan and sticking to it – these are not sexy things.   But they are proven, time-tested tools for securing a financial future -- elements of a strategy employed by the world’s most successful investors, including a guy named Warren Buffett.

As for the money-related thrills?  Budget another weekend trip to Las Vegas with your college pal.  It will be just like day trading – except with an awesome (and cheap) buffet.