Study: Most short-term trades lose money
Just because trades can be executed faster than ever doesn’t mean they should. In fact, a new study shows money managers are not doing their clients any favors by being shortsighted.
The research shows that institutional stock traders will likely get better returns by taking a more long-term approach.
In the article, “The Performance of Short-term Institutional Trades,” a team from Cornell, Saint Louis, and Indiana universities found that most institutional trades held for three months or less lose money. The losses occur in all types of stocks, with the lowest returns occurring in small stocks and value stocks.
The researchers examined the holding periods and returns of more than a million buy-and-sell trades across a decade, ending in 2009. They found that 99 percent of the institutional funds execute round-trip trades lasting less than three months, and more than 23 percent of the volume include such trades.
One of the researchers was Pamela C. Moulton, associate professor of finance at Cornell University’s School of Hotel Administration.
“For institutional traders, the key is to realize that short-term trades are on average not earning positive returns,” Moulton said. “It is hard to make money in short-term trades, but longer-term trades—specifically, those held a year or longer—do earn positive returns on average, even after adjusting for stock characteristics.”
She added, “If portfolio managers had held their short-term trades for at least one year instead of reversing them within three months, they would have been profitable on average.”
Why so many losing trades?
According to the researchers, one reason fund managers engage in so much unprofitable trading is that they overreact to events, expecting that money-losing trades will do even worse in the long term despite a lack of evidence. Another reason is that institutional traders feel the need to demonstrate that they are earning their pay, as they are closely monitored by either mutual-fund advisors or pension-fund clients and have performance-based contracts. However, trades that are executed without reliable information are more likely to lose money.
“Institutional traders and all active traders should be on the alert for behavioral biases that may be influencing how long they hold trades,” Moulton said.
This brings about two important questions:
- “Are they trading simply to look active—to show they are doing something—when it would actually be wiser to hold positions longer?”
- “Are they reacting too strongly to recent price moves (a form of ‘recency bias’) and abandoning their thesis too easily?”
Hanging on to the position can result in a positive return in the longer term, she said.
The researchers say they found evidence of both types of behavior.
Details of the study
The article will be published in the Journal of Financial and Quantitative Analysis. The other researchers were Bidisha Chakrabarty, professor at Saint Louis University, and Charles Trzcinka, professor at Indiana University. Their research looked at 105 million trades between 1999 and 2009, with a total volume of over 291 billion shares.
Instead of relying on quarterly reports to identify stock portfolios as short-term or long-term, the researchers used a data set containing daily transactions to precisely identify round-trip trade-holding periods. They suggest that this is the first study of its kind to evaluate the profitability of trades over different holding periods using data that show exactly when institutional traders buy and sell.