Trader Volatility

Trader volatility arises when trades are made for purposes unrelated to the fundamental values of a business. These trades drive prices to points related more to the motives of the trader than to the business value of the company.

The wide range of trading decisions that cause price moves unrelated to business value includes trading for identifiable economic reasons of the trader, such as portfolio rebalancing selling shares to fund personal needs or desires, such as a child’s education or the remodeling of a kitchen and, most notoriously of all, day trading for purposes of speculation and gambling. Let’s start with that one.

Day trading is usually not based on fundamental values but on momentum, sector rotation, and other technical tactics of the type ridiculed earlier. When trades are based on these things, they move prices. Those moves, having nothing to do with values, widen the gap between price and value. This exacerbates Mr. Market’s peaks and valleys and feeds irrational exuberance and irrational despair.

Day trading is thus among the worst developments capital markets have seen in their history for purposes of maintaining an orderly or sensible market, much less an efficient one. Many day traders are probably perfectly rational people, many are not. Aberrations may get headlines, but some of the day trader stunts captured by the mainstream press warrant attention. The Atlanta day trader who gunned down nine people and then himself in the summer of 1999 after suffering staggering day trading losses is a glaring example. So too is the fun-loving 44-year-old family man who took early retirement with his wife and their $780,000 nest egg only to murder the money day trading and then attempt to murder his wife. Hardly tales of high rationality, and the woeful tales of these hapless folks are not isolated examples or aberrations. A Senate committee held hearings on day trading in early 2000 accompanied by a blistering report cataloging its numerous plagues. The report focused on the industry that supports day trading and emphasized the need for greater industry risk disclosure, licensing, and minimum financial requirements for traders. But it is also a brief against the sagacity of the pernicious practice.

The most compelling conclusions of the report are that 75% of day traders lose money and that a typical day trader has to generate gains of $110,000 a year just to break even after costs. That figure is breathtaking, but the idea is not new. Classic studies have shown that someone who tries to time the market and move in and out of it quickly to exploit its gyrations has to be right 70% of the time to profit. Do you know anybody who can perform that well consistently? Even the best hitters in baseball say, Rod Carew, George Brett, and even Ted Williams bat at most .400.

An equally important if slightly more benign source of trader volatility is the practice of “rebalancing.” Ironically, this practice was promoted mainly by those who use modern portfolio theory and believe in market efficiency. Rebalancing goes something like this: If you start with ten stocks each bought for 10% of the total cost of your portfolio, some will rise in price and some will fall. The rebalancer says that after a year or another arbitrary interval, look at the new pricing. Suppose five went up and five went down, both in proportion. Now your portfolio has five stocks constituting 75% of the holdings and five stocks constituting 25%. The rebalancer says you should shed some of those in the 75% group to reduce their role in the overall holdings.