Information advantage is zero-sum: whatever one side gains, another side must lose. So who gains and who loses? Sorted by why they trade, traders fall into three groups: utilitarian traders, who trade for benefits other than trading profit; profit-motivated traders, who trade for the profit itself; and futile traders, who believe they can make money but on average do not. Before costs, the money that profit-motivated traders make comes from the other two groups. The losses of utilitarian traders buy them real benefits; the losses of futile traders buy them nothing.
In Trading and Exchanges: Market Microstructure for Practitioners (2003), Harris argues that to understand a market, one must first understand why the people in it trade. He sorts traders into three groups by motive:
In a 2015 monograph written for the CFA Institute Research Foundation, Harris revised this classification and no longer lists futile traders as a separate group. This chapter follows the 2015 version as its backbone, but takes futile traders and their subtypes from the earlier versions (the 1993 working paper and the 2003 book), because that category best explains the position of individual investors.
Taken together, all investors hold the whole market, so their combined return can only equal the market return. Trading merely redistributes that return among investors: whatever one side gains through trading, another side must lose. Once trading costs are deducted, traders as a whole earn less than the market, and the zero-sum game becomes a negative-sum game. French estimated in 2008 that from 1980 to 2006, the fees, trading costs and spreads that US investors paid each year for active investing averaged about 0.67% of the market value of stocks.
In this game, the winners are the part of the profit-motivated traders who have a genuine edge; the losers are utilitarian and futile traders. Trading costs are borne by everyone and flow to brokers, exchanges and market makers.
Utilitarian traders lose on their trades on average, but that does not make their trades mistakes. An exporter will receive a payment in US dollars in three months. To lock in what that payment will be worth in its home currency, it sells dollars forward today. On average this costs a little, but the firm buys certainty: however exchange rates move, its profit will not swing because of them.
Hedging: a little less on average, in exchange for certainty
An exporter will receive a payment of US$1 million in three months. Simulate 400 possible exchange-rate paths and see the distribution of the income in yuan.
The logic is the same as buying insurance. Expected payouts on insurance are lower than the premium, yet people still buy it, because what they are buying is protection against bad outcomes. Investors who buy in order to carry money into the future, and sell because they need the money, are likewise trading for purposes other than trading itself; the trading costs they pay are the price of those benefits.
Trading for enjoyment also counts as utilitarian. Dorn and Sengmueller (2009) found that investors who say they enjoy investing or gambling turn over their portfolios about twice as often as others. Kumar (2009) found that individual investors favour "lottery-type" stocks: low-priced, highly volatile stocks that occasionally soar. The price they pay buys entertainment; the problem is that many of them do not know how much they are paying.
Profit-motivated traders earn their profits from different sources and play very different roles in the market. In his 1993 working paper, Harris compared the types of trader by whom they profit from, how they affect price efficiency and how they affect liquidity. This is the best way to understand them.
Informed traders push prices towards value and make prices more efficient. Dealers and arbitrageurs supply liquidity to people in a hurry to trade and are paid with the bid-ask spread. Parasitic traders are different: they bring no information, but try to anticipate other people's large orders and trade ahead of them, profiting from other people's trading costs. Market manipulators mislead others by spreading rumours, placing fake orders and similar methods; these practices are expressly prohibited by law in every major jurisdiction.
The most common position of futile traders is that of the "pseudo-informed": they believe they hold valuable information, but the information is either already reflected in the price or has no predictive power at all. A large body of evidence on individual investors points to this group.
About 66,000 US household accounts, 1991–1996: average annual net return
Barber and Odean (2000)
Share of day traders in Taiwan who earn consistent profits after fees
Each dot is 1% of day traders; the orange part is less than one dot. Barber, Lee, Liu and Odean (2014)
Barber and Odean (2000) studied about 66,000 household accounts at a US discount broker. From 1991 to 1996, the 20% of households that traded most earned an average net return of 11.4% a year, against a market return of 17.9% over the same period. Barber and colleagues (2014) studied day traders in Taiwan and found that fewer than 1% earned consistent profits after fees. Barber and Odean (2008) also found that individual investors' purchases are driven largely by attention: stocks that are in the news, show unusually heavy trading volume or have the largest price moves are the ones individuals are most likely to buy.
Futile traders do not stay futile forever. Seru and colleagues (2010) found that individual investors' trading performance improves with experience, but an important source of the improvement is that people who lack the skill reduce their trading, or stop altogether, once they realize it.
Different trading motives call for different kinds of help from a product.
Whether for retirement, currency exchange, hedging or entertainment decides what help is useful; motive is used only to serve the user, never to label them.
Trades that are not urgent can be filled patiently; show the spread and fees before an order is placed, and calculate the cost actually paid in the review afterwards.
Do not use number of trades or turnover as product metrics; do not use leaderboards or streak rewards to stimulate trading; mark news with its time and the price change since it was published.
Refuse to help spread rumours, place fake orders and the like, and keep records.