02.02.09

So you want to be a stock trader? (Part One of Many)

Posted in All Categories at 10:01 pm by Michael Goode

I am a professional stock trader. I sit in my home office all day and look at numbers on my computer screen clicking here and there. For some reason, people believe that stock trading is sexy, fun, or a worthwhile hobby. It is not. It is perhaps one of the most difficult pursuits available because it is a zero-sum game. For every winner there is a loser. Whereas if you are a hand surgeon or a statistician or a synthetic organic chemist or an entrepreneur you can make money just by being good at what you do, if you are a stock trader you make money only if you are better than the traders that take the opposite side of your trades. In other words, the second best entrepreneur might become a billionaire. The second best trader will lose money. If you are interested in trading stocks I will give you some pointers, but first I will explain why most of you should not trade stocks.

Types of Games

Negative-Sum Games

In game theory, there are three basic types of games. There are negative-sum games, in which everyone who plays loses (and the outcome determines only the extent of the loss). The classic example of this is global thermonuclear war (if you have not seen the movie War Games, see it). In any conceivable global nuclear war every side incurs massive loss of life and infrastructure. The unrealistic best-case scenario for a country might involve losing 2/3 of its population and having 50% of its land mass rendered uninhabitable. A more realistic ‘victory’ scenario would involve 95% loss of life and 90% of a country’s land mass rendered uninhabitable. Clearly no one would wish to play such a game.

Yet, another example of a negative-sum game is mutual funds (and particularly the largest funds). On the whole, they make up so much of the market that they cannot realistically outperform the market. And after expenses, they are guaranteed to underperform the market. So on average, mutual fund investors would be better off if they all invested in low-cost index funds. This is exactly the point that Warren Buffett’s Gotrocks parable in his letter to shareholders (excerpted here).

Okay, you say, you think other people should use index funds, but you are smart enough to pick good fund managers. Oh really? But what if the probability of any one fund outperforming is not better than random chance (and that is before fees)? Oh, and those “growth fund managers” that outperform their benchmark? That is only because there is such dreck in their benchmark (like American Superconductor or Ener1 at the moment), stuff that is so odious it is easy to avoid. But growth benchmarks on the whole underperform the broad stock market, meaning that even if growth fund managers can reliably beat their benchmark, they will underperform the broad market (as measured by the Dow Jones Wilshire 5000 or a similar index).

I could go on, but this article is not focused on mutual funds. I just wanted to illustrate the concept of negative-sum games in finance.

Positive-Sum Games

The opposite of course is a positive sum game, where each player expects to win, although the degree of winning may differ. Spin the bottle is of course an example of this type of game. Any cooperative game (the type I hate playing, which is why I cannot think of more examples) would qualify as a positive-sum game.

The stock and bond markets are positive-sum games for long-term investors, because the expected return from stocks and bonds is positive. So in picking stocks, on average everyone makes money. Some people will lose money because they invest emotionally or stupidly and are not diversified, but on average stocks and bonds provide a certain positive return. That return on the whole (for stocks) comes from economic growth (ultimately driven by population growth and productivity growth) and dividends.

Zero-Sum Games

Zero-sum games are of course the most common when we think about games. Some common games include chess, checkers, and betting on football games (although that becomes a negative-sum game if you place it with a bookie, because the house takes a cut). Stock trading is also a zero-sum game. When you are literally day-trading stocks (buying them), holding nothing overnight, your expected market return will be about zero, because your transaction costs will nullify the tiny expected daily gain of the stock market. Looked at another way, the market return on such a short timescale is irrelevant; all that matters is whether you can outsmart another trader who takes the opposite side of your trade.

Even if you buy and hold stocks as an investor, you are betting that the stocks you buy will beat the market. In that sense, you are playing a zero-sum game (trying to beat the market) with professionals who are a lot better and smarter than you. Why would you play that game?

A Million Grand Masters

Do you play chess? Would you imagine that by studying chess for a few hours a week you could become a master, let alone a grandmaster? Would you then believe that you could go up against Garry Kasparov? Studies of experts in various fields have generally shown that to reach an elite level of performance (whether playing a musical instrument or chess or catching a football) takes something on the order of 10,000 hours of practice. That is three hours a day for ten years. Worse, those who achieve that elite level of performance start when they are very young, when their capacity to learn is much greater.

You surely would not attempt to take on Garry Kasparov if you were but a lowly chess master, let alone a dilettante who cannot beat a simple computer chess game. Yet many people, knowing little about analyzing companies, think that a few hours and a couple books prepares them to beat professional investors who spend 60 hours a week on investing or trading.

It is not necessary for the stock market to be efficient for amateur investors or traders to have very low odds of succeeding. It is only necessary that there be professionals who can profit off of the idiocy of the amateurs.

The Impossibility of Mastering Multiple Skills

If you spend 40 to 50 hours a week at your day job and a significant amount of time with your family and friends, then you do not have enough time to master another skill. I am a great example of this–when I first started to learn about investing and trading while in graduate school I devoted more and more time to learning investing, such that by the time I decided to leave school my advis0r was unsurprised, because I had not been a very productive or good graduate student. Mastering one subject left me little time to master another. Even a man much smarter than myself, the famous cognitive psychologist Richard Shiffrin, experienced the same problem. In graduate school he started playing the game Go and eventually reached the level of 6 dan, perhaps roughly equivalent to a chess master; yet he realized that he had to quit either Go or psychology if he wanted to master one. Thankfully, he chose psychology. You are probably not as smart or dedicated as Rich or myself, so don’t believe you can master a skill without devoting absurd amounts of time to it.

While stock trading is not as difficult as Go, it requires a lot of time to study patterns and learn what does and does not work. Most dilettants do not have the time or focus required to do it right.

Most Traders Lose Money

Most stock traders lose money. For day traders in Taiwan, the figure is 80% over any 6-month period. The figures are probably similar in the USA (one study finds that 20% of US daytraders make decent amounts of money). Many of those are just lucky or trade using a strategy that ceases to work; they do not continue to make profits over a period of months and years. Keep in mind that studies like these greatly overestimate the probability of a trader making money because they focus on those who trade the most; by using that there is a selection bias: traders who make money will trade more; those that lose money will tend to quit. If you could survey all the people who have tried daytrading, even just briefly, I am sure that fewer than 1% make any money while many lose large sums.

Okay, I Warned You

If you still wish to learn about trading, read on. Hopefully I have scared you enough so that you will not try it. In the followup article to this I will address different trading methodologies and strategies.

Okay, I’m Warning You Again

If you want to stand a chance at making money trading, here are a few suggestions of things not to trade: Apple (AAPL), GE (GE), Amazon.com (AMZN), and any other well-followed large-cap stock (or index or ETF). The big hedge funds have programs and experienced traders that trade these stocks based on thousands of statistical factors, news, and many other things I cannot even imagine. There is no point in trying to trade these. You have no edge whatsoever.

Another bad idea is to trade based on news or rumors. The hedge funds and iBanks hear the rumors first, so you won’t stand a chance (I’ve ignored that one a few times). The same thing goes for news as for rumor–the big traders hear it first. And with news they have programs to read the press releases and SEC filings and instantly make trades (that is what happened when a years-old report of United Airlines’ bankruptcy mistakenly hit the wires back in September: program trading sent the stock down 50% in minutes). If you trade solely based on what you do know (price momentum), you can make money, but you will be trading blind. This is what some traders I know did with UAUA and what I did with Constellation Energy (CEG) when there were rumors that it would go bankrupt. If you do this you are at a huge disadvantage.

If you do wish to trade stocks, the key is to have an edge. Whenever you want to do something, whether investing in a random stock or trying a quick day-trade, ask yourself: “What are the risks?” and also ask yourself, “Why aren’t other smart investors / traders / hedge funds doing this trade and taking this opportunity away from me?” You will quickly realize that most “trading ideas” have no value and that you almost never have an edge.

Coming soon: Part Two, How to Become a Trader

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