In Defense of Day Traders

In Defense of Day Traders

In Defense of Day Traders

Moneybox
Commentary about business and finance.
Dec. 14 1998 3:19 PM

In Defense of Day Traders

While there's no question that the perpetual frenzy over Internet stocks has added a new chapter to the long history of financial manias and panics, there's a detectable--and ill-conceived--snobbishness in the media's criticism of that frenzy. (Not in my criticism, of course. Just in all the other criticism.) That snobbishness has shown itself most clearly in the recent uproar over the boom in day traders, who have apparently been responsible for much of the action in Net stocks over the past few months.

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Day trading is both a crazy way to spend your life--do you really want to spend all day monitoring a ticker's minute up-and-down movements?--and a fool's game for those who want to beat the market. But pronouncements about the nefarious effects that day trading will have on U.S. capital markets are wrong.

Today's New York Times, for instance, suggested the impact of the Internet was to create "a model for exponential growth" in the spread of stock trading away from "the purview of an elite few." It argued that eventually this could mean "a situation where the market as we know it today cannot absorb the shock." The implication was that in the good old days investors were more rational and patient, and that as the hoi polloi get involved, the chances for chaos grow. "When herd behavior moves the larger markets in these highly volatile ways," one source said, "that becomes highly problematic."

Actually, what's problematic is the idea that as more people become investors, the more likely you are to have fits of herd behavior. The thing to remember, and that the Times appears to have forgotten, is that the profit-maximizing impulses that we assume drive institutional investors also drive individual investors, even if they're day traders. As a result, in the collective, individual investors are as likely to come up with the "right" price for an asset as the old-boys'-network was.

That's because although markets are not perfectly efficient, they're pretty damn efficient. Any systematic mispricing will almost instantly be recognized and taken advantage of, and that is true of a market in which the traders are white-shoe traders or short-sleeved day traders. If anything, the more people you get involved in a market, the fewer chances for profit there will be.

But how do we square this with the reality of Internet stock prices, which seem by any rational measure to be insanely overpriced and which are breathtakingly volatile? In part, it seems to be a simple matter of supply and demand, since most Net companies have not yet gone back to the market to offer more shares. When they do, you should see prices decline some.

In part, though, the prices also reflect the youth of the market. Young markets tend to be more inefficient, since no one is really sure how assets should be valued or what the future looks. As a result, very small changes in one's initial assumptions can lead to wild swings in price, which after all is an attempt to discount the future. As the market ages, those swings should moderate. I hope. In any case, I'd prefer it if the day traders were spending at least some time looking at the fundamentals of the companies they're buying. But if their approach is truly suicidal, they'll disappear, and if it's not, then they'll only help the market's efficiency. Wall Street, don't fear the groundlings!