I read something today that, as a fiduciary to retirement plans and advisor to their participants, scared the heck out of me. Knight Ridder/ Tribune ran a story reporting that more and more retirement plan participants are day trading in their 401(k) accounts. For the uninitiated, day trading is a practice where securities, usually stocks and options contracts are traded multiple times per day. Positions are rarely held overnight. The reason given for the rise in popularity of day trading in retirement accounts is impatience with today’s low return environment and frustration with losses generated during the financial crises.
First let’s dispel any doubts about the effectiveness/profitability of day trading by individual investors. The most definitive study of day trading in a juried (reputable) economic journal comes from Jordan and Ditz (Financial Analysts Journal, Nov. – Dec. 2003). These researchers concluded that twice as many day traders lose money as make money and that only 20% of day trading accounts were even marginally profitable after fees. Most of the studies I have seen that claim to prove that day trading by non-institutional investors could be profitable were published prior to 2006 when loopholes in NADAQ’s Small Order Execution System (SOES) that allowed small volume day traders to circumvent bid-ask spread regulations were changed. This change eliminated a trading anomaly that day trader’s frequently exploited. These studies, however are still frequently quoted by those hawking, books, courses etc. that purport to teach day trading methods. In short, day trading by individual investors is extremely risky and rarely works.
We are concerned that investors are being pushed/lured into higher risk investment strategies by today’s low return investment environment, particularly those that leaned heavily toward fixed income investments in the past. Patience, while required to be a good investor, is commonly not an abundant human trait. We see 401(k) plan participants pursing any number of strategies that are much riskier than what they have used in the past in an effort to “catch up”, frequently we find that these are investors who suffered heavily during the financial crisis as they sold at the market bottom. We cannot emphasize enough that the right way to invest is to work with an independent, fee- only financial advisor to design a portfolio that fits your tolerance for risk and stick with it. As proof to the effectiveness of this I offer the following:
We back tested a balanced portfolio constructed of the Signal Share Class of four Vanguard index funds, 40 % Vanguard Total Bond Market Index (VBTSX), 35% Vanguard 500 Index(VIFSX), 14% Vanguard Total International Stock Index (VTSGX)and 10% Vanguard Extended Market Index ( VEMSX). If you had a retirement account in June of 2007 and reacted to the “great recession” by doing the right thing, which was nothing. You would have earned +2.89% over the last five years which included a -35% peak to bottom drop in the S&P 500. Your return in this portfolio over the last ten years would not have been the zero return “Lost Decade” apparently experienced by most U.S. investors but +6.31%, not too far from the historical average of 7.4% for this type of account. Over the last three years you would have pocketed a handsome 11.76% annualized return and participated in the second best bull market in history. All that for doing absolutely nothing but buying and holding a diversified portfolio of low - cost index funds, and paying only 0.10% in fee and expenses. Folks who fled to cash equivalents (Money Markets, T-Bills & Stable Value Funds) during the crisis by the way have earned 0.03% annualized over the last three years, after probably experiencing large losses by selling during the market collapse.