If Trading Is So Bad, Why Don’t Statistics Show It?

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The conventional wisdom is that trading is risky, and those who engage in it can lose everything. For example, the Forbes article “If Trading of oracle ascension coin farming Is So Bad, Why Don’t Statistics Show It?” says: “The fact that trading on the stock market has a relatively high probability of losing money has led many people to conclude that trading is bad for society.

1. It is true that trading on the stock market has a relatively high probability of losing money. 

First, the S&P 500 Index has averaged approximately 11.5% over the most recent 20-year period, and second it is widely acknowledged that about half of all trading on a stock exchange takes place in one direction only — executing buy or sell orders — and that these trades do not make money but cost money . The losses from these trades outweigh the profits from those who trade in both directions — buy low/sell high — especially when one considers the transaction costs involved in placing trades.

2. What is not true is that this means trading “has a relatively high probability of losing money. 

This distribution is slightly negatively skewed, but in no way can it be considered “relatively high” or even “high.” It means that a $1 million investment in the S&P 500 Index would decrease by about $1 million with a probability of 48.4%. In other words, there is about a one out of two chance (48.4%) that an investment would decrease by $1 million over any given time period. On average, this will happen once every two years, and twice out of three years it will never happen at all. This is hardly a “high probability” of losing money.

3. The Forbes article also says: 

“If trading is so bad, why don’t statistics show it? How can the frequency of trade be one-way and the index rise?” In fact, statistics do show that it cannot be so. That this happens in practice is due to market participants who engage in order flow only, i.e., in one-way trading for their own accounts (as opposed to for those of customers) or for the accounts of others who pay them to do so. These market participants bid up the price on buy orders and sell orders push it down, creating very large positive and negative return variances that offset each other in aggregate.

4. Looking at the individual-level statistics 

From the 2007 ACIS data, market participants in the U.S. equity markets have an annualized gross return of approximately 12% per year. However, this gross return is offset by trading costs of about 2.4%. Using a net return of 10.6% per year, an individual investor making $100 trades has an annual probability of a loss higher than 50%, and on average makes no money after five years, even though net returns are positive on average at the group level. 

5. Finally, the Forbes article claims that 

The “results are consistent with academic studies, which show that in a large number of situations a small number of people can disrupt the overall market.” The implication is that this is evidence against market efficiency. The reality is that the empirical evidence on average response times in econometric studies is known to be biased downward. This effect arises because there are many time series observations in each country and each time series has different response patterns, which leads to higher average responses than would be observed if all countries or all time series were considered together.

6. In contrast 

To the claims made above, it is very clear that average return, as well as the distribution of returns, are highly skewed and very different from those found in normal distributions. This is shown by looking at the ACIS data on excess returns (Does anyone know how to do a permutation test?).

7.  And finally, 

If stock trading truly were “so bad” why would any investor ever want to engage in it in the first place? Expanding upon Nash’s theorem , which says that if all investors make identical decisions and all investors pursue maximum expected utility (and all investors have the same information), then no one can make a profit by trading without taking risk.

Summary:

A few points

1. The figures reported regarding average returns and investor losses from stock trading are none too encouraging.

2. These numbers should make us all aware of their hidden costs: the huge transaction costs that are part of the game since stock trading is only a small part of overall investment choices. The S&P 500 Index has an annualized gross return of approximately 12% with transaction costs of about 2.4%.

3. The hollow and unconvincing nature of the Forbes article will encourage people to give up even more on the basis of such simplistic, misleading claims.

4. Only a very tiny percentage of investors trade for themselves (for example, Vanguard Total Stock Market Index Fund has about one-half percent) so we are in no way affected by their behavior.

5. Since most investors do not engage in one-way trading (as opposed to buy and sell orders ordered by others), we can feel quite confident that they have taken the time to carefully read all available information before making an investment decision, and they have been fully capable of weighing both expected returns and expected risks.

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