The Lucky Chump

Prabhat had a few words to say on my last post, although he read an awful lot more into a general, sweeping post than I intended. He writes:

You clearly believe in the somewhat ludicrous efficient market hypothesis. A couple of reasons to think it's absurd.

1. There's enough statistical evidence that most retail traders consistently lose amounts of money (far exceeding transaction costs), implying obviously, that doing the opposite of what they did would yield a profit.

2. There are many traders who have very long track records of success. I am familiar with the "thousand monkeys hypothesis", but really it's a non-falsifiable claim that anyone who is a winner is lucky. Would you really lay even money on George Soros having a winning year?

3. You say "unless of course they have some kind of an edge, which would be illegal". Only insider information is an illegal edge, and even that doesn't apply to futures and commodities, forex and the like. Superior analysis is an edge that people can have.

I could replicate all of your arguments and apply them to sports-betting too, are you just a lucky chump, no matter that you've been a winner over sample sizes greater than 10/20,000 games?

Sorry for the rant, but I detest this defeatist, mediocre nonsense about financial markets being efficient and 'no one can beat the market, don't even try'.

If you are so sure markets are efficient, why invest in index funds? That's an implicitly bullish bet as well? How can the market be efficient if it's more likely to go up then down?

Marty responded:

Because systematic risk justifies a return for that risk

A couple of clarifications - I never said, clearly or otherwise, that the financial markets were efficient. I don’t believe the word ‘efficient’ appeared anywhere in that post, not even in a quote, so be careful what you assume.

The point I was making, or was trying to make, is that Joe Bloggs, sitting at his desk in suburbia, will always know less about the value of a stock than people whose full-time jobs are to trade in that stock. I’m talking about individuals like myself – not hedge funds which pay lobbyists five figure sums each month for tips on upcoming legislation and whose “investments in information” buy them an advantage over many participants. I’m talking about my old friend the chemist, who gave up his job to make a living day-trading, an experiment that didn’t last too long once the market took a tumble. Superior analysis is an edge that people can have – yes, but big players in the markets, not individuals like myself.

In my opinion, it’s not defeatist, mediocre nonsense at all – it’s called being a realist. If Prabhat likes to think he has an edge in the financial markets, then good luck to him. I accept that I don’t, that I never will have, and I make the best of it. As an individual, I don’t care about ‘beating the market’. This isn't a zero-sum game. I'm not competing with anyone else, I'm not beholden to shareholders to maximise returns and I’m not a fund manager looking to impress prospective investors - I’m an individual interested in my own money. If my returns are the market average, then I’m beating half the people (or money) in the market anyway, and expecting more than this long-term isn’t realistic for Mr Chump.

Why invest in index funds? Historically the best long term investment for keeping ahead of inflation has been stocks.

Why index funds rather than managed funds? Because the fact is that most investors are better off investing in index funds than managed funds.

Why? Because — due to the high costs of active management — the majority of actively managed funds fail to outperform their respective indexes. In fact, according to a study done by Standard and Poors, for the five-year period ending 12/31/11:

§ Less than 39% of U.S. stock funds managed to outperform their respective indexes,

§ Less than 22% of international stock funds managed to outperform their respective indexes, and

§ Less than 25% of government bond funds and less than 23% of investment grade bond funds managed to outperform their respective indexes.

Now, lest you think that this particular period was an anomaly, let me assure you: It wasn’t. Standard and Poors has been doing this study since 2002, and each of the studies has shown very similar results. On average, actively managed funds have failed in both up markets and down markets. They’ve failed in both domestic markets and international markets. And they’ve failed in both stock markets and bond markets.

Sports betting markets have many similarities to the financial markets, but there are also huge differences, not least of which is that liquidity in the former is relatively minute.

Also, sports take place before our eyes, and all we should need is our skill in updating probabilities as events unfold, but events impacting stock prices are unlikely to reach my living room before the market finds out about it. Unfortunately these days, as I may have mentioned before, events in sports are being seen before they reach my living room, so the lucky chump may have to settle for average here too. Except that in a zero-sum game, average doesn't cut it of course. And worst news is that the title for my memoir has been taken!