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Post No.: 0563stock


Furrywisepuppy says:


We should always remain humble when making predictions. But there’s an ‘illusion of skill’ in stock market trading that’s often hubristic, even though it all essentially boils down to gambling (unless an investor is illegally insider trading). It’s primarily a game of chance – more like rolling dice than playing poker.


There’s some nous involved in fairness. Amateurs tend to perform worse than professional investors because they tend to ‘lock in’ or ‘bank’ their gains by selling stocks that have appreciated, and hang onto stocks that have depreciated, since they bought them. This is despite recent winners usually performing better than recent losers in the short run. The above tendency is due to ‘mental accounting’. Amateur investors also tend to flock to companies that have recently been in the news, whilst professional investors are more selective when listening to these stories.


So professional investors may win a lot more from amateurs than vice-versa – but even they struggle to beat the market year after year. It’s not technically a skill if one cannot do something repeatedly and reasonably consistently, time and again, whenever called upon. If someone can hit the target with their free kicks extremely consistently then that’s a skill, but if someone cannot reliably replicate success in something they’ve attempted many times before then that’s not really a creditable skill. Skill is replicable, so if you, say, made lots of money from a cryptocurrency investment but cannot do it again then it’s more about luck than skill.


Having said that, not all strings of successes are evidence of skill either – the chances are miniscule but people can e.g. luckily flip 20 heads in a row with a fair coin, and some people do, and are going to do, that in this world, especially if we look at all of the flips in the world in time and place ever. Therefore luck can occasionally come in long streaks too i.e. luck will not always immediately regress to the mean. But such patterns are only illusory and these outliers are meaningless, just like flipping 20 heads in a row. So just because some traders appear to do well compared to others on a repeated basis, this should be expected based on the probability distribution of something that’s predominantly down to chance. One-in-a-million events do happen – one-in-a-million times.


More conclusive is that the statistics on the results of ‘top’ stock traders show that the year-to-year correlation of their results is near enough zero i.e. doing well in one year doesn’t mean doing well in another year. Imagine if top sportspeople played like that! Trading stocks (and other types of financial assets too) is overwhelmingly down to luck, even if there are some short winning streaks.


There are overall no persistent individual differences – the year-to-year correlation between outcomes is tiny or close to zero, unlike the rankings of golfers or tennis players. Of course, the winners will likely claim that it was down to their own skill rather than luck because of biases of perception, and other people in general will believe this too because of the very same biases. In the media, we hear people coming forwards and gasconading about their wins if they win, but of course if they lose then they don’t want any media attention at all (and this happens in all kinds of contexts), thus biasing the coverage with famous winners but faceless losers (where faces are more salient than plain statistics too).


Everyone thinks they’re making sensible, educated guesses, but in highly efficient markets, they’re no more accurate than blind or random guesses. It’s not a question of being well-trained or not – it’s a question of whether one’s world is predictable or not. Hence why, in several experiments, novices have performed better than professionals on their first attempts at stock trading. Imagine if that ever happened between a novice and a professional archer, chess player, cook or mechanic! One cannot be skilled in an unpredictable or inconsistent domain, such as stock market trading.


If a stock is surely so rubbish that one must sell and offload it, then why is someone else buying this very same stock from this seller? They both have the same informational facts (unless one side is illegally insider trading again) thus the only differences shaping the seller’s and buyer’s opinions are their feelings and emotions i.e. the seller thinks that the market valuation for the stock is too high and is likely to drop, whilst the buyer thinks that it’s too low and is likely to rise. But what makes them both believe that they know more about the right price than the market does, that the current market price is wrong, and with completely opposing directions of opinion too?! Their beliefs are fuzzy illusions. The markets are chiefly ruled by sentiments and ‘confidence’ (hence are often described in emotional terms e.g. volatile, bullish).


They’re trying to beat the market – but doesn’t the market know best?(!) A stock’s free market price, at any given time, already fully incorporates all of the available knowledge and information about the value of that company and the best aggregated market prediction about the future of that stock i.e. its net present value. (Well if it were just about how the company is doing today then many stocks would be (less than) worthless because many companies with high share prices haven’t turned a profit yet. Some are even making yearly multi-million dollar losses despite being valued at billions.) If all assets in a free and efficient market are correctly priced (according to the ‘efficient-market hypothesis’) then no one should expect to either gain or lose by trading. Thus it’s ironic for traders to believe that they, as individuals, know and can do better than the market itself because it’s contrary to the precise economic hypothesis that most of them subscribe to i.e. that the market price is the correct price of things!


So, say, if a trader sees a share price valued at $10 then he/she should actually say, “The aggregate view of the free and efficient market states that it’s worth $10 so it’s worth $10, and I’m just me so I shouldn’t think I know better to guess that it’s under or over-valued.” Thus, without using illegal methods that are against free trade principles – if we do decide to bet that the market is wrong, we’re counting on luck, not skill.


Also, for every winning transaction/winner, there’s a losing transaction/loser – it’s zero sum e.g. +1 + –1 = 0 (without accounting for transaction costs like commissions). Therefore, because for every winner there’s an equal but opposite loser – on average, stock traders are no better or worse in stock-picking skill or intelligence than the general population or compared to random guessing. You can’t buy a stock at a certain price unless someone else is willing to sell that stock at that price, and similar when trying to sell a stock at a certain price – hence if someone guessed right by an amount then someone else guessed wrong by the exact same amount. And it’s safe to assume that everyone’s trading because they want to generate as large a return as they can rather than make a loss. Exactly half of the time then, on average, a trader would’ve therefore done better doing nothing at all(!) (Now when one football team wins, another loses, but they can also draw, and still make money even if they lose.) This also highlights why the stock markets aren’t really where value is created in an economy.


Yes, there are skills in reading financial statements, examining the quality of firm management, examining economic data, the news, the competition, trends, etc. (financial analyses) – but these don’t actually count for much in trading success, where the key question is whether the information about a firm is already incorporated properly into its stock price; which it should be. Historical results don’t reliably predict the mid-to-long-term future in this domain either (technical analyses). And in the short-term, one should trust more that the current market price is likely already spot-on because the potential error is small in the short-term and only increases in the mid-to-long-term. It’s also about trying to guess what other traders are going to do in the future, but this is an even worse blind guess than trying to guess what oneself is going to do in the future concerning the question of which exact stocks to buy or sell and on which exact day (or even second)!


If a share price goes up by 25% within an hour, then falls by 25% the next, then that doesn’t reflect reality because no business is fluctuating in trade or negotiated deals that fast! Indeed, it’s frequently not about speculating upon company valuations based on their future profitability but about speculating upon whether other traders will buy a stock at a higher price than what one bought it for, possibly within timescales of minutes or just nanoseconds in the future. So the time horizon is often incredibly short. But this leads to booms and busts, as over-exuberant prices will eventually meet reality. The prices will self-correct, but in potentially shocking ways that has disruptive effects for economies as a whole if entire industries have been over-hyped e.g. the dot-com bubble. But how do traders guess what other traders are going to do?


Share prices are about speculation, whilst net profits are the true measure of a business’s financial success. And things like superstitions, biases (unless for ethical reasons perhaps), (over)confidence, how one felt when one got out of bed, and emotions like greed, fear and regret, are what drive trading decisions, hence it’s probably more useful here to have an education in psychology than anything else. (Read Post No.: 0523 about superstitions.) Woof!


Although most stock traders believe that trading is down to skill – even those who do understand that it’s essentially down to luck still feel that their remunerations are justified! It’s ingrained in the culture of the sector. People can maintain an unshakeable faith in any proposition, however absurd, when they’re sustained by a community of like-minded believers. It’s (equivalent to) their religion. So it’s not surprising that people in this financial sector believe themselves to be amongst the ‘chosen few’ who can do what they believe others cannot (when others could if they were gamblers and crucially had a large pot of money to play with too). Facts that challenge and threaten people’s selfish interests and self-esteem aren’t absorbed – they get ignored or somehow excused away and people carry on as usual, especially if they’re profiting greatly from the situation. If one is profiting from a sweet deal then one will likely not care about the truth or other people (especially people or groups one never sees), and one would rather everyone believe in the piffle that’s being peddled when it’s favourable to oneself.


People tend to ignore statistical facts and dispassionate, rational evaluations of their personal experiences when they clash with their own personal emotive impressions derived from experience. This is similar to believing that one knows better than the aggregate market. And to financial pundits in the aftermath of any major or minor economic event too – everything appears to makes sense, with the benefit of hindsight, and so everything seems to ought to have been predictable back in the past, with this benefit of hindsight.


Woof! If the markets are efficient, and if the total market tends to only grow in the very long run, then it’d be more rational to trust in the market as a whole by investing in an already diversified index fund that tracks the total market as a whole, then leaving your money there for a very long time; rather than believe that one can personally beat the markets. This’ll also save you the transaction costs involved in continually buying and selling individual stocks and managing a pawtfolio.


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