The High Price of Cheaper Stock Trades

First, bad traders started trading more. After the tax cut, the day-trading volume in the 14,000 day-trading accounts increased by 30 percent, the researchers document. They conclude that this was a direct result of the reform, noting that the volume of other trading in these accounts (which didn’t qualify as day-trading) didn’t change nearly as much.

The researchers partitioned day traders by account size, which is a common proxy for sophistication. Investors with the smallest accounts demonstrated the worst skill, typically losing money with each trade. But when costs fell, these investors increased their trading by 45 percent, versus 22 percent for the largest investors.

“This reform made the average investor worse off because there were a lot of losses from the less-sophisticated investors,” says Chen. “Somehow these less-sophisticated investors are the ones who think of lower costs as being more valuable, and they increase trading a lot. That is the reason they lose more money.” This, he says, is the primary reason that lower costs backfired on investor returns.

But the researchers also find a secondary explanation, which is that investors traded not just more but differently. For example, traders started relying more often on cognitive shortcuts such as placing more orders at round-number prices—say, $10.50 rather than $10.48. The Taiwanese market does not permit instant, at-the-market trades. Instead, all trades must be limit orders that specify either the highest price an investor will pay to buy shares or the lowest price they’ll accept to sell them. The share of round-number orders rose by 2 percentage points, or 7 percent from the pre-reform mean. Chen and Lin posit that the increased use of rounding reflects a focus on quick and easy trades rather than more targeted strategies.

Moreover, the researchers also find that in the wake of the tax cut, day traders paid less attention to their orders. They were 4 percent more likely to ignore an open limit order, which made them more vulnerable to missing market moves. The probability of modifying or canceling orders dropped by nearly 1 percentage point. Day traders also focused more on newsy, buzzy stocks. After the reform, investors’ trades become more concentrated in stocks that saw a lot of volume overnight.

This change in trading behavior dragged down day traders’ performance on a per-dollar basis. Before the tax cut, these investors had, on average, grossed 0.28 percent per dollar traded. That entire amount was paid out in trading costs, leaving a negative net return. The tax cut mechanically returned 0.15 percent per dollar traded, and yet investors didn’t keep all of that. Their average net returns rose only 0.1 percent per dollar traded.

Some investors saw their performance climb into break-even or positive territory, but not the least sophisticated investors, who still had negative net returns. And those negative returns were compounded by the additional trading.

In the end, while the cost savings should have raised the average portfolio return by more than 1 percent, returns instead fell by 0.8 percent—and less sophisticated investors did far worse. They had been losing about 6 percent of their portfolio each year, the researchers estimate. But after the tax cut, those losses fell further, to about 9 percent.

But the tax cut did work as intended, as it encouraged more day trading and improved the overall functioning of the market by enhancing liquidity. The fact that this better market quality came at the expense of day traders highlights a challenge for policymakers, the researchers write. Regulation of practices such as payment for order flow—where brokers offer zero-commission trades to retail investors and profit from routing those trades to third-party platforms—is already a hot issue. This research raises the prospect that removing or reducing the friction of trading costs may come at a high cost for individual investors, since lower trading costs appear to encourage more trading, and that generates worse returns for individual investors.