February 5, 2021
How much money retail traders lose
Zero-commission trading apps make trading accessible to everyone. As California-based brokerage firm Robinhood puts it, they are "on a mission to democratize finance for all." As their name indicate, zero-commission trading brokers do not charge any commission to their clients.
If you're not paying, you're the product.
The reason why trading apps offer their clients to trade for free—and even push them to trade for free as much as possible—is because retail traders tend to make losing trades. When a retail trader buys a stock at $100, he will eventually resell it at $98 on average. The trading app makes profits by offering hedge funds to trade against the retail trader. This practice is called selling the order flow. For example, the trading app sells the right to trade against the client for $1 to a hedge fund. The hedge fund is happy to pay $1 because selling at $100 to buy back later at $98 generates $2 worth of expected profit.
Robinhood earned $600 million of revenue from selling the order flow in 2020. This amount must represent trading losses for the trading app's clients, otherwise why would hedge funds be willing to pay for trading against them?
Retail traders losing money is the norm, not the exception.
Academics crunched data on retail day trading from countries all over the world and found that, unfortunately, retail traders losing money is not the exception, it is the norm.
Day trading is very popular in China and Taiwan. The average Taiwanese lose a staggering 2.8% of their total personal income by trading in the stock market. These losses are not because stocks are a bad investment. These losses arise because many people keep churning their portfolio and each transaction loses a little bit of money at the expense of sophisticated financial institutions—and also because of commissions when people trade on non-zero-commission brokers.
My colleague at HEC Paris, Finance Prof. Jean-Noël Barrot, studied the performance of French retail investors. He found that the French lose less money than the Taiwanese because the French trade less, but each trade they do is equally losing. The average trade of a French retail investor loses 2.7%. This number means that while the average return of stocks is positive, each trade costs 2.7% of the value of the trade. This cost can be avoided by holding stocks over the long run.
Stocks are for long-term investing.
That the average day trader loses money does not imply that stocks are a bad investment. Stocks are a good investment in the long-run. It is generally a good idea to invest long-term savings such as retirement savings in the stock market.
But day trading is, on average, money-losing. Unless you can outsmart other traders. But not everyone is smarter than average, and even fewer are smarter than hedge funds.
Source: The research on retail trading in Taiwan is by Barber, Lee, Liu and Odean, Just How Much Do Individual Investors Lose by Trading? Review of Financial Studies 2009.