New UBC Sauder School of Business research shows that active traders end up with more risk and lower returns
A handful of online investors recently made a fortune on the Reddit-fueled run-up of GameStop and other underperforming stocks but a new study from the UBC Sauder School of Business shows that people who try to time the market are more likely to end up on the losing end of the equation.
Previous research has already shown that active trading that is, frequently buying and selling in hopes of timing a stock's highs and lows often leads to lower returns than buying and holding.
But a new UBC Sauder study, titled The Volatility of Stock Investor Returns, reveals yet another layer of risk: active trading also increases the volatility of a portfolio. In other words, investors who try to time the market are not only getting lower returns; they're assuming more risk as well.
For the study, the researchers examined nearly 100 years of New York Stock Exchange (NYSE), American Stock Exchange (AMEX) and Nasdaq data, from 1925 to 2018. Rather than simply relying on the volatility of buy-and-hold returns over that period, they also calculated using dollar-weighted (DW) returns, which more accurately captures the effects of market volatility over time.
"For example, if you inject $1,000 today, that has a very different implication than if you inject $1,000 two months from today, because the market conditions are very different, and the stock prices are different," says co-author and UBC Sauder assistant professor Dr. Xin Zheng.
"So, we believe this new measure is a more accurate reflection of investors' actual experience."
Using investment horizons from five to 30 years, the researchers found a significant difference in volatility. For example, over 20 years, active investors actually experience almost 50 per cent higher volatility than the buy-and-hold volatility of stock returns.
The effect is even more amplified over time, with active investors experiencing 71 per cent more volatility over a 30-year stretch than the buy-and-hold stock volatility.
The irony, says Dr. Zheng, is that people who actively trade are usually seeking stability that is, they're trying to reduce volatility by buying and selling stocks at just the right moment. Instead, they tend to buy after a stretch of market stability, just as volatility is increasing, and sell after a period of instability when they would be better to hang on.
"When the market has been calm and they feel comfortable, they inject money, but then the market becomes volatile and they start to lose money. The reverse holds true when they withdraw money from the market: they do it after a period of volatility," explains Zheng, who co-authored the study with Emory University professor Dr. Ilia Dichev.
"So basically, these investors aren't riding the wave correctly. They're chasing stability, but they're doing it completely wrong."
The study is the first of its kind to create a more accurate, and more revealing, measure of volatility, and the results were consistent across markets in Canada, France, Germany, the U.K. and Japan.
The research is especially timely given the skyrocketing popularity of retail investing platforms such as Robinhood and Wealthsimple, which have taken off during COVID-19.
Dr. Zheng says the platforms can be helpful tools for DIY investors, but it's problematic that they promote active trading by constantly sending notifications even celebratory bursts of electronic confetti when stocks are moving up or down. As a result, it can feel more like a game or casino play, and investors feel pressured to buy and sell more often.
"The worst part is they constantly execute trades, which they shouldn't do. Investors shouldn't be on their phones constantly. They can monitor as much as they want, but trading is costly and it contributes to overall market volatility, which will affect their own stocks," says Dr. Zheng, who offers one simple piece of advice for people managing their own portfolios.
"Trade as little as possible."
