One trading rule to never break ?

Gaurav Rastogi

4 years ago

Table of Contents

Don’t trade.

You read it right. That’s the one trading rule retail investor should never break.

If trading is not your day job i.e you do something else for a living, then don’t ever break this rule. I can’t tell you how many times I have heard this story – a friend of a friend made a killing trading stocks. It is always a friend of a friend. And always has a promise of quick riches.

But data says otherwise. So let’s look at some evidence on retail traders returns.

In their landmark paper “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors”, researchers at The Haas School at Berkeley note

“Individual investors who hold common stocks directly pay a tremendous performance penalty for active trading. Of 66,465 households with accounts at a large discount broker during 1991 to 1996, those that trade most earn an annual return of 11.4 percent, while the market returns 17.9 percent. The average household earns an annual return of 16.4 percent, tilts its common stock investment toward high-beta, small, value stocks, and turns over 75 percent of its portfolio annually.”

In another paper this time looking at retail traders return data from Taiwan titled “Just How Much Do Individual Investors Lose by Trading?”, researchers note

“Individual investor trading results in systematic and economically large losses. Using a complete trading history of all investors in Taiwan, we document that the aggregate portfolio of individuals suffers an annual performance penalty of 3.8 percentage points.”

Less comprehensive studies suggest that trading losses and costs for individual investors in the United States are about 2 percentage points a year. Also, retail traders quit trading at an alarming rate. About 75% of retail traders stop trading after 2 years, and as many as 90% stop after 4 years due to trading related account losses.

Over a savings horizon of 20 years, an annual return shortfall of 2% vs the index will result in a ~45% reduction in potential wealth and can dramatically change your lifestyle choices.

So if you thought ‘hey, there is no harm in some fun trading’, well that’s the cost of fun then. I am sure you can find more amusing and far cheaper options easily.

Finally, the biggest evidence against trading is what I call the law of missing data. Let’s assume that retail traders were truly killing it out there, earning outsized gains.

Then it would be reasonable to expect two things to happen:

Brokerages or trading platforms would make lifetime portfolio returns (XIRR) part of the data they show to traders. After all the easiest way to get you to trade more is to show you that you get higher returns trading than investing in index funds. Not a single platform does that – globally.

A lot of brokerage data would be published showing how well the retail traders have done on their platforms. No such studies exist either. Instead, brokers publish news, trade ideas and use as many behaviour nudges as they can with the aim of increasing trading churn.

It’s not that the brokerages haven’t done the math. These are smart businesses. The only reason you don’t see XIRR on your trading platform or see brokerage return studies is that it is not worth showing. It will hurt the brokers business.

But what about taxes Gaurav?

Glad you asked.

The real-life trading performance data referenced above does not include taxes. In India, 15% tax applies to short term gains and 10% applies to long term gains for equity.

So that would dock your trading strategy returns an additional 1 – 1.5% every year.

The real return shortfall vs a simple index buy and hold will be closer to 3 – 5% after including India’s tax regime into account.

All the data that exists that looks at retail trading returns come to the same conclusion – the average retail trader loses a lot in returns for the privilege of trading

So be a contrarian. Don’t trade.

Happy investing,
Gaurav
CEO | kuvera.in | @rustapharian

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