Why casual trading is for suckas
Jul. 12th, 2010 12:37 pm![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
snousleFrom 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'.
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'.
