Why casual trading is for suckas

[snousle]

From Less Wrong:

Stock market losses due to irrationality are not atypical. From the beginning of 1998 to the end of 2001, the Firsthand Technology Value mutual fund had an average gain of 16 percent per year. Yet the average investor who invested in the fund lost 31.6 percent of her money over the same period. Investors actually lost a total of $1.9 billion by investing in a fund which was producing 16 percent of a profit per year. That happened because the fund was very volatile, causing people to invest and cash out at exactly the wrong times. When it gained, it gained a lot, and when it lost, it lost a lot. When people saw that it had been making losses, they sold, and when they saw it had been making gains, they bought. In other words, they bought when high and sold when low - exactly the opposite of what you're supposed to do if you want to make a profit. Reporting on a study of 700 mutual funds during 1998-2001, finanical reporter Jason Zweig noted that "to a remarkable degree, investors underperformed their funds' reported returns - sometimes by as much as 75 percentage points per year."

This is why I cringe when anyone wants to tell me about their fantastic trading strategy. Every time you buy or sell a financial instrument, you are paired up with someone making exactly the opposite transaction, and thinking that they're getting the better deal. Most of those opposing trades are backed by actors with extremely sophisticated analysis capability, WAY beyond what is available to ordinary people, and they will totally pwn you. The surest sign of economic folly is the belief that any kind of common sense can outwit the market. It can't, but it very often gratifies the casual investor with the illusion of success, just before wiping them out entirely. "But nine out of ten of my trades were profitable, how can I be broke???"

A common paradox is rooted in the confusion between how often a prediction is correct, versus how much it is correct. For example, a blanket statement of "gold will go up in value" is a great prediction when evaluated according to how often it is correct, but this "success rate" of no value whatsoever to investors. This is because when it's right, it's generally just a little bit right, and when it's wrong, it's really wrong - many small increases in value are countered by a relatively small number of precipitous declines. Because this is among the most emotionally charged of financial instruments, casual traders are especially vulnerable to miscalculations that consider frequencies while ignoring magnitudes.

Much of what happens in the American economy is, at its heart, the systematic exploitation of irrationality and innumeracy by people who know how to work the numbers. The financial crisis, viewed from this perspective, was really no accident at all. A lot of accusations of "stupidity" and "incompetence" have been flying around over this, but before calling someone stupid, maybe it helps to ask how much money they made? Just sayin'.

Comments

[oscarlikesbugsy.livejournal.com]

"to a remarkable degree, investors underperformed their funds' reported returns
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ROFLMAO.

This isn't even the worst of it. In a mutual fund, it is not just you buying and selling at the hypothesized unsophisticated moment, as described above.

It's also the people who are selling at the sophisticated moment.

So, I can remember, for instance, circa 2001, after the tech bust, that some people took the early advice and sold out of the tech funds at the top, leaving a huge capital gain in the fund. At the end of the year, of course many of these funds were bust, some down over 40%. Then, at year end tax time, on top of your 40% loss, you get hit with a capital gains "distribution" which is taxed.(!)

Screwed, therefore, standing or moving, in some circumstances.

Of course, one has to hesitate about attributing too much to the systematic exploitation of irrationaility. A lot of the real money flows from more conventional means. Consider how many companies force their employees to buy mutual funds in their 401(k)s. Of course, they could easily allow people to buy anything they want, but that does not happen. All that is required, then, to make money, is to be average and not get kicked out of "the program".

The occurs partly because the alternative is to allow people to avoid the fee monsters. However, there are many, many, many people out there who think their internet connection is their telephone number, proverbially speaking, so one can only imagine what would happen if left to make up their own minds about what constitutes a safe/reasonable investment for retirement purposes...

Actually, one doesn't have to imagine. There are benefits companies who have done studies. It's scary.

[come-to-think.livejournal.com]

In Vol. I of Feller, on p. 346, footnote 2, we read: "A certain man used to visit Monte Carlo every year and was always successful in recovering the cost of his vacations. He firmly believed in a magic power over chance. Actually his experience is not surprising. Assuming that he started with ten times the ultimate gain, the chances of success in any year are nearly 0.9. The probability of an unbroken sequence of ten successes is about (1 - 1/10)^{10} ~ e^{-1} ~ 0.37. Thus continued success is by no means improbable. Moreover, _one_ failure would, of course, be blamed on an oversight or momentary indisposition.

This fact is exploited by private gamblers as well as casinos. A wonderful book by a man who used to make a living playing poker (it used to be on the Web, but the URL no longer works) taught the lesson: The most valuable losers are ahead most of the time.

[snousle.livejournal.com]

The most valuable losers are ahead most of the time

That is a wonderful quote. It's been my observation for a long time that smart people let losers think they've won. ;-)

[h0gwash.livejournal.com]

While some financial companies accurately predicted the crash, IMHO the real genius was creating a situation where you can be stupid and incompetent and STILL avoid liability. I guess if you call it fraud, it isn't actually stupid, it's evil genius.