• Michael Weiss

An Empirical Analysis on Day Trading

Updated: Sep 19, 2020

Image Credit: WSJ; Jon Krause

If you are considering getting into day trading, you might be better off taking your money to the casino.

Last month, Mark Hulbert from the Wall Street Journal put out an interesting piece on the growing popularity of day trading. It discusses empirical results from 3 statistical tests, where investment returns were analyzed through mathematical models and ultimately attributed to true skill or simple luck. The author then applies the formulas to investment newsletter and fund returns to determine if their strategies are skillful, or just plain lucky.

Below, I summarize the primary findings behind these tests, and then discuss what it means for you and your investment strategy.

Test #1: Dispersion of Returns

The first experiment mentioned in the article was conducted by Bradford Cornell, an emeritus finance professor at UCLA. He compares the role of luck through the dispersion of investment returns in short-term vs. long-term time horizons. In short, Cornell measured volatility profiles and found they were more widely dispersed in the short-term compared to long-term. He rationalizes his findings by saying that a much higher proportion of short-term returns are simply attributable to lucky guesses.

Hulbert then uses Cornell’s formula and applies it to hundreds of investment newsletters and even large-cap US equity mutual funds, which are both known to employ day trading strategies. When putting the same group of investment advisers under one microscope, the difference between the best and worst performing month over a 1-year period is a stark 81%. Conversely, the range for a 15-year investment horizon is just 11%. Skill can’t possibly explain much in the short term when the returns are so volatile.

When exclusively using Cornell’s model, Hulbert ultimately finds that 92% of the differences in newsletter returns are attributable solely to good (or bad) luck.

Test #2: Reversion to the Mean

The second test discussed in the article was developed by Michael Mauboussin, managing director at Counterpoint Global, a division of Morgan Stanley Investment Management. In his book “The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing”, he explains the historical facts behind the ebbs and flows of performance rankings amongst fund managers. He highlights how quickly a top-performing manager can move to a 2nd, 3rd, or 4th quartile ranking (or vice versa) within a single month. Mauboussin hypothesizes that the quicker the upgrades or downgrades occur, the more luck is attributed to performance.

Hulbert cleverly relates Mauboussin’s test to the degree of skill in chess vs. luck in flipping a coin. A professional chess player will beat an amateur about every time, and so you would say he is "skilled". But if you flip a coin and it lands on heads, you have no control over the outcome of the second flip.

Likewise, you would expect a top-performing fund manager to remain in the top quartile for subsequent years. However, if pure luck is at play, that same manager would fall just above or below the 2nd quartile (+/- 50%) in the following year.

The return data legitimizes this generalization. When looking at the top-performing newsletters in year 1, on average, they rank in the 51st percentile in year 2, which is almost the same probability of landing heads or tails – just purely random. It’s even more of a shot in the dark when looking at actively managed funds; only 3.84% of US equity funds maintained consecutive 1st or 2nd quartile status in the 5-year period beginning 2015 through the end of 2019.

Test #3: Noise-Reduced Alpha

The final test involves some complex financial engineering and introduces the concept of “Noise-Reduced Alpha”, a term coined by finance professors Campbell Harvey (Duke Biz School) and Yan Liu (Purdue). The concept involves isolating a certain manager’s historical returns that are attributed to skill only, and then independently using the measure as a basis to identify his/her ability to perform above their benchmark.

In Harvey and Liu’s study, they found that pure skill is rare; more than 90% of managers who outperformed their benchmarks did it because they were lucky in picking the right securities. However, we can look to the anomaly of the Medallion Fund (a hedge fund managed by James Simons of Renaissance Technologies) when attributing skill to successful day trading. Simons has done so well in his day trading strategy, that according to Professor Cornell, “it is impossible to attribute it to mere luck.”

Image Credit: WSJ

But an individual day trader can’t replicate these insane returns. Simons' strategy involves managing thousands of open and covered short-term positions, all with institutional capabilities. Even then, the Medallion Fund is only accurate in 50% of its trades, but since it can replicate them over and over again, the fund is able to generate billions of dollars in returns.

What This Means For You

If you’re a self-proclaimed day trader, and you make money doing it, kudos. But as Professor Cornell concludes: “For most investors, any deviations [of returns] from an index fund are essentially all luck. They may just not know it.” So, you may have a really good day in the market, and but an awful day the next (just about every other day in 2020?). As much as you’d like to control what happens in the market, nobody can, and very few people (even professionals) can correctly predict what will happen.

I think it’s important to evaluate the true reason why you are putting your money to work. Are you trading? Or are you investing? Does your strategy align with your financial goals? Can you stomach an 81% loss in one year? Or would you rather buy and hold equities based on the fundamentals? Ask yourself these questions and don’t treat the markets like you’re betting on the Lakers game.

Don’t get me wrong, I have fun speculating and looking at technical analyses from time to time, but I do that with “play money”, and as an individual investor this isn’t a part of my long-term strategy.

Join the Conversation

Are you a day trader? What are some of your successes and failures, and what did you base your strategies on? Do you think luck or skill played a bigger role in your returns? Share your thoughts in the comments below.

Disclaimer: Nothing on this page constitutes as any sort of financial advice and is meant solely for the purpose of sharing thoughts and ideas. To avoid employer compliance and FINRA violations, I do not, and will not discuss any proprietary information that comes across my desk at work. Every link and piece of information on this page is readily available to the public via the internet.


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