If you’re looking for answers related to trading and whether you trade for a living, keep reading because on this post we’ll explore multiple questions beginners often have about trading.
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The hardest question is whether you can actually make extraordinary gains by trading the market actively, that means is there any reason to spend hours looking at charts and analyzing companies or will you make the same money as if you would’ve just invested in an index fund.
Finance and the Survivorship Bias
There’s a very relevant fallacy we need to talk about before we further explore the question of extraordinary profits, this fallacy is called survivorship bias and it basically means that the winners of events that are entirely random often attribute their success to skill even if the contests/game or wherever they are competing is a game of chance. It also means that people often only look at what the winners did without realizing that a lot of the losers did exactly the same thing.
There’s a very popular idea that Burton Malkiel discusses in A Random Walk Down Wall Street where he argues that markets are so unpredictable that even the best managers who spent years at the best business schools and have very expensive tools with the latest technology can’t consistently beat the market. He claims that a group of monkeys throwing darts randomly at a list of stocks can beat the market as consistently as the best Wall Street Managers. This has actually been proved multiple times, it’s a fact that most managers fail to consistently beat the market, so the real question here is how do we determine what was due to luck and what was due to skill?
Coins and Markets
Let’s do a thought experiment to illustrate the point, imagine that you have one million people flipping coins, on the first round of the tournament you will have 500k people picking heads and the other half will pick tails and at the end of the round 500k will have guessed right, now comes second round and 250k will win again, and they continue for 10 rounds. At the end of the 10th round you will have around 960 people who guessed 10 consecutive times right, at this point they will probably believe they have a system to guess right every time and they will sell you courses on how they use charts to determine whether the coin will land on heads or tails.
I’m sure you can see where this is going, the argument claims that most economists and traders who have made good predictions don’t necessarily know what they are doing. After all the financial markets are the greatest casino in the entire world, open 24/7 the 365 days of the year (even when the US Stock Market is closed you can trade the DAX, The NIKKEI, FOREX etc.) and it’s traded by millions of people every day so there’s bound to be some people who will “guess right” 20 or 30 times in a row, but do they really know what they’re doing?
So we’ve talked about the argument in favor of the efficient market hypothesis (stocks are unpredictable) but now let’s see the counter-argument, (from the book More Money Than God by Sebastian Mallaby) in a now-famous debate (from 1984) where Warren Buffett “smashed” the efficient market hypothesis. Buffett and Michael Jensen (Economist and influential professor) where basically debating whether extraordinary returns where due to luck or skill, Jensen made the argument we’ve already discussed including the monkeys and coins. Basically building a very strong argument on why Buffett’s wealth was only due to luck, but Buffett’s counter-argument was even better, Buffett asked what if all the successful monkeys came from the same zoo? The argument is pretty solid what are the chances that Warren Buffet’s mentor Benjamin Graham was also successful and so were Buffet’s disciples, let’s imagine that beating the market in a given year is binary, you either achieve it or not and let’s say the probability of beating the market are of 50% the probability of beating the market 20 times consecutively would be of 0.001% (0.5^20) or around in one in a million, which could’ve happened as we already discussed but now imagine that there’s like 15 investors who have done exactly that following the same principles and strategy, the probability of their success being due to luck decreases drastically to the point of being statistically impossible which is why Buffett’s answer was so strong and still remains very relevant.
That being said we’re not all Warren Buffett, but he’s not the only one who’s cracked the code, others have beat the market through “arbitrage” which consists in finding inefficiencies in the market and exploiting them sometimes even using leverage to get the most of the inefficiencies. Arbitrage basically means that there are some assets that are not being correctly priced, sometimes there are assets that have different prices on different markets so you could buy the cheap one in the cheap market and sell it for a certain profit in another, eliminating the inefficiency (by buying the cheap one you raise the price of the cheap “asset” and by selling the “expensive” one you lower its price by increasing the supply). However, finding inefficiencies is very hard for obvious reasons and they don’t tend to last long.
Another manager who has beat the market consecutively enough to discard the hypothesis of his success being due to luck is James Harris Simons with his Hedge Fund ” Renaissance Technologies” who has made returns of more than 40% per years for decades now, sadly there’s not really a lot of information on what type of strategy he follows, though it’s speculated that he exploits arbitrage opportunities he finds through complex algorithms which would make sense since Simons is a cryptographer who used to work for NSA cracking codes.
So, can the market be beaten?
Evidence seems to point towards a highly efficient market but not perfectly efficient which means that with the correct knowledge traders could actually predict future movements in some cases, though we need to make emphasis on how hard beating the market actually is, the chances of beating the market by just using the typical charts of technical analysis are ridiculously low for the simple reason that everyone’s using them and any inefficiency that could be found with those charts is exploited immediately as soon as it appears. But who knows maybe with the right combinations of indicators or with the new tools available like machine learning, there still might be some chance of beating the market.
What do you think, does trading for a living still makes sense, can markets be beaten? please leave your thoughts and opinions in the comments below.