Thursday, December 8, 2011

Schmitt, 401(k) Day Trading

Over the past couple of weeks I have reviewed several books that meticulously explore the viability of various investing and trading strategies. Richard Schmitt’s 401(k) Day Trading: The Art of Cashing in on a Shaky Market in Minutes a Day (Wiley, 2011) does not fall into this category.

Schmitt argues that the investor with unconsolidated 401(k) accounts can outperform buy-and-hold returns by trading part of his retirement portfolio once every day. How, you may ask, can he do this given the restrictions on frequent trading imposed by most mutual funds? It’s simple. He has two commission-free stock fund accounts, one for buying stock and the other for selling stock, and a cash fund. And here’s the strategy. “You use one account for transfers just before the market close from a stock fund to a cash fund whenever the stock market is advancing for the day. In the other account, you transfer from a cash fund to a stock fund when the market is declining for the day.” (p. 220)

The investor doesn’t swap out his total buying or selling account each day. Instead, he determines how much to exchange based on the S&P 500’s daily change (not the daily range) multiplied by a constant calibration factor. “Under normal conditions, you could use a calibration factor of one thousandth of the initial amount of your retirement savings portfolio you decide to subject to day trading.” (p. 194) So, if the investor had a $100,000 portfolio, the S&P moved 10 points, and his calibration factor was $100, he would exchange $1,000.

Schmitt provides very little statistical information about his backtesting of this method. He compares only the differences in returns between the $100,000 day trading portfolio and the $100,000 S&P 500 portfolio. To “accommodate the market volatility experienced during the decade ended December 31, 2010,” the backtested day trading portfolio used a calibration factor of $75 for each daily one-point change in the S&P 500 index. (I assume this figure was optimized in hindsight, warning flag #1.) The day trading portfolio outperformed the index portfolio over the ten-year period (120 vs. 95.3) and a five-year timeframe (115.1 vs. 100.7). In 2010 itself, however, the index portfolio outperformed 112.8 vs. 107.3. We have no data on portfolio drawdowns.

The author acknowledges that “a comparison of alternative asset management strategies relies heavily on the measurement period selected for use in computing the strategies’ investment returns” (warning flag #2). “A 20-year comparison of alternative strategies becomes a bit more interesting.” (p. 207) We don’t know how badly Schmitt’s strategy would have performed over that time frame. Suffice it to say that the author acknowledges that “day trading is a strategy of the times, but not for all times. It may perform well in a volatile stock market with little or no net change over time but does not fare as well by comparison in a rapidly increasing or decreasing stock market.” (p. 208) So, warning flag #3 is that the investor has to be able to read the tea leaves of the market environment, present and near future.

Schmitt’s book provides a lot more information about 401(k) plans than I have shared in this review, and to that extent I have been unfair. But before investors with 401(k) plans get all excited about a way to earn excess returns with very little work they should step back a bit and think it through.

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