Why You're Bad At Picking Stocks

And even worse at selling them

Dec 02, 2024

a man with glasses is looking at a laptop — Photo by Francisco De Legarreta C. on Unsplash

I am trying something new with today’s post.

I’ll be adapting a portion of a chapter from my book, The Rational Investor.

I wrote the book a few years ago now, and I recently re-read it and was surprised by how much information about investing was packed into that book. The amount of research I did for that book took a major toll, and the only reason I was able to dedicate that much time to it was because we were in COVID lockdowns in 2020, and I had nothing else to do.

All this is to say, the book contains a treasure trove of investing research, and I think it’s important for us to all revisit it from time-to-time so, every once in a while, I will rehash one of the chapters.

Today, let’s revisit the research behind why day trading is such a lousy way to build wealth.

What is day trading?

As the name implies, day trading is when assets are bought and sold over a very short period of time—often within the same trading day.

Two common financial assets that day traders buy and sell are;

Stocks
Options

The reality of trading stocks

The top 0.5% of stocks bought every day on Robinhood lose about 4.7% over the next month.

That was one of the findings from a recent research paper titled “Attention Induced Trading and Returns: Evidence from Robinhood Users.”The researchers studied data from Robinhood to determine the impact on individuals’ trading and stock prices.

They found the most intensely bought stocks on the app tend to lose money after users jump on the bandwagon. This is not a surprising outcome, as this is the exact phenomenon we reviewed in an earlier chapter of the book during our discussion of thematic ETFs. But it’s interesting to have empirical evidence backing up what should be obvious: trading stocks is an easy way to lose money.

The researchers hypothesize two reasons Robinhood users underperform:

Robinhood attracts inexperienced investors.
Unique features of the app help facilitate “attention-induced trading.”

Let’s review the evidence that explains why those two ingredients are a recipe for terrible investment returns.

Here’s why you’re bad at trading stocks

A 1998 paper written by Terrance Odean, a professor at the Haas School of Business, University of California Berkeley, asked a simple question: “Do Investors Trade Too Much?”

(Spoiler: yes, they do)

Odean analyzed 10,000 trading accounts at discount brokerages to understand the performance of retail investors who regularly trade stocks. He found that retail investors were engaging in excessive trading that caused them to underperform.

To make money trading stocks requires you to get two things right.

Buying the right stock at the right price.
Selling that stock at a higher price and trading it for a better-performing stock.

Odean found that the average retail investor was not that bad at buying the right stocks; the problem was they were terrible at knowing when to sell those stocks.

They couldn’t stick the landing.

Here’s how Odean phrased it.

On average, the stocks that traders sell outperform the stocks they buy next.

Translation: traders would make more money by simply holding the stocks they have rather than continuing to trade— the term for this would be excessive trading.

Why selling stocks is so difficult

To understand why it’s so hard to nail the sell-side of a stock trade, Professor Odean gives us a lesson in behavioral finance.

Professor Odean explains the concept of a “reference price,” which is what an investor “perceives” to be their breakeven point, where they would be indifferent on whether to hold or sell a stock. The word “perceives” is the keyword there because the wild swings in stock prices can radically alter our perceived breakeven point.

In the paper, professor Odean uses the example of a homeowner who bought their house for $100,000—if that seems like an absurdly low price for a house remember, this is a 1998 paper.

$100,000 is their breakeven point.
But if the housing market goes bonkers and the price increases to $200,000, after a while, the homeowner adopts $200,000 as their new breakeven point.
They might be unwilling to sell for less than $200,000 even if the market dictates a lower price in the future.

Think about how that might play out in the situation with a stock.

You buy a stock at $30 per share.
It quickly jumps to $60.
Eventually, you might view $60 as your new reference price. If you sell below this, you “feel” like you are losing money even though you’re not.
So, you hang onto the stock even as it continues to slide downwards.

The opposite is also true.

You buy a stock for $60 per share.
It quickly drops to $30. This really hurts as investors feel much more intense emotions from losing money than they do from making money.
After a while, the price rises to $40.
You’d be more willing to sell that stock at $40 even though you’re losing money because your reference price has dropped below your actual breakeven point of $60.
You’re desperate to get out of this “loser” and are willing to sell at a loss.
Then, you buy a new stock and repeat the process even as the stock you just sold climbs back up to $60 and beyond.

Trading “popular stocks” is an easy way to lose money

There are tens of thousands of publically traded companies in the world, but most day traders focus on a tiny fraction of those stocks.

We even have a name for them now, “Meme-stocks.” These are stocks that are generating lots of buzz online. Limiting your investment opportunities to the select number of stocks that are driving the news is an easy way to lose money.

A 2021 research paper titled “Internet Search, Fund Flows, and Fund Performance” used Google search volume as a measure of investor attention to explore the connection between investment funds that were grabbing headlines and the future performance of those investments.

If an investment fund saw a spike in Google searches, the researchers wanted to know how much money poured into the funds after that spike in traffic and how the fund performed.

They found that retail investors were more likely to buy these funds that were generating online buzz. Unsurprisingly, these attention-driven investors had negative future returns.

It’s a pretty simple picture to paint.

Search traffic for an investment fund is highly correlated with its past returns.
Once a fund does really well, it gets investors’ attention.
Investors pile into the fund, expecting the fund to continue to outperform.
This is called “return chasing.”
Predictably, these superstar funds tend to perform poorly after everyone has piled into them.
The most recent investors who bought at the top lose the most money.

The most relevant quote from the paper:

“Investors cannot generate superior fund-related future returns when they exclusively follow online buzz and associated suggestions.”

This explains why the most traded stocks on Robinhood lost 4.7% the following month. Making investment decisions based on what’s “popular” is completely devoid of logic.

To make matters worse, social media influencers often encourage inexperienced users to engage in higher-risk, complex trading schemes like options trading, where losses can mount even quicker.

Oftentimes, these same influencers are selling a product, “teaching” you how to make money by investing as they do.

That last point about buying investing courses reminds me that there is another part of the book where I explain research that shows that there is no evidence that the average day-trader can “learn” to improve their trading skills. Maybe we will revisit that topic in a future post.

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