Stupid but essential question

[eastbay]

I have read countless times that traders can't beat the market. You're better off buying an index and holding, because this is the best you can do. Every trade is simply throwing money away on commission from this baseline return.

True or false?

If true, why do investment banks employ traders? Sure they should know better if it is not possible to "win"?

If false, why is this claim made so consistently?

eastbay

[RacersEdge]

Coming from the University of Chicago - the bastion of tne free market economy thinking - I can say the idea of not being able to beat the market as an personal investor is one taught there. Things like market timing, asset allocation, etc can get lucky in the short run but have no long run validity by this theory.

But this theory rests on the idea that markets are what's called strongly efficient - i.e. all available information about a stock is alrady contained in the price of the stock - so a stock picker can have no additional knowledge over the market. Obviously, this concept is debatable. So if you buy into the idea that guys like Peter Lynch can process knowledge differently than an average person, than you might invest in his funds.

One difference though - and someone who works closer to I-banking can give more specifics - but the trading that analyst do for an I-bank is a little different than an everyday consumer trading. The professional traders are using models to detect the slightest discprepancy in prices and trading in huge volumes that would offset any transaction costs that exist. IOW, when you take a job as a trader for an I-bank, you are in a different world than going into investment management for a company like Fidelity.

[parttimepro]

Two reasons:
1. Pro traders have a huge information advantage over retail investors. They know who else is in a market, what their strategies are, etc. Some them get inside information from brokerages, so they can see movements before their competitors do (Steven Cohen's hedge fund is well known for this. While most heavy traders demand volume discounts, he doesn't. In exchange, he gets information about who's buying what). Arbitrage opportunities exist, but they're exploited very quickly by pros. Trying to trade on a retail level is like playing poker where you don't know who else is playing or how many people are playing, and you can only see one of your cards.

2. A smaller advantage: Institutions have the resources to move markets, when appropriate. They can stage bear raids or short squeezes to exploit vulnerabilities that you don't even know about. Small investors can only try to ride the waves generated by these moves.

[OrangeCat]

There are many kinds of traders. Investment banks and brokerages make a ton of money trading for their own accounts. If you are talking about individuals, yes they certainly can do better than the S&P 500. However, most individual investors/traders end up losing money but I think this is because they are usually looking for a quick score and fail to put the in the effort to learn how to trade/invest well.

Like RacersEdge said, the idea that trying to beat the market is futile stems mainly from the efficient market theory. The EMT has some logical flaws, such as , (1) traders do not always act rationally and (2) traders do not always reach the same conclusion from a given piece of info.

Warren Buffet doesn’t think much of the EMT either. He said, “Investing in a market where people believe in efficiency is like playing bridge with someone who’s been told it doesn’t do any good to look at the cards.”

Contrary to popular opinion, doing well in the stock market does not require inside info. A lot of things are fairly obvious and the trends have been going on for years. For example, war in Iraq (oil stocks go up), people are getting older (HMO stocks go up), gambling is booming (casino stocks go up), low interest rates (housing stocks go up), etc…

[eastbay]

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Contrary to popular opinion, doing well in the stock market does not require inside info. A lot of things are fairly obvious and the trends have been going on for years. For example, war in Iraq (oil stocks go up), people are getting older (HMO stocks go up), gambling is booming (casino stocks go up), low interest rates (housing stocks go up), etc…

[/ QUOTE ]

That sounds pretty woefully inefficient, kind of like your basic mid-stakes poker game where most players haven't done their homework and don't really care to - they just want to play cards.

I have seen numbers that show that most mutual funds don't beat the S&P 500. This does seem like powerful evidence that an individual investor would have an extremely difficult time beating the S&P 500, since they probably have a day job and don't have the tools available to the professional fund manager.

Is there some reason this should not be as persuasive as it sounds?

eastbay

[Paluka]

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I have read countless times that traders can't beat the market.

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This is obviously a gross overgeneralization. I think this is usually said when referring to quasi-professional day traders, who are basically paying commissions to gamble. There are obviously plenty of professional traders who make money, but I'm not sure what they do is considered "beating the market". Most professional traders do not do the same sorts of trades that someone would do in their personal account.

[eastbay]

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There are obviously plenty of professional traders who make money,

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Who make more money than they could have made just riding S&P 500?

To show you how truly insulated I am from this entire culture: I would suspect so but don't actually know it to be true.

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Most professional traders do not do the same sorts of trades that someone would do in their personal account.

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What do they do, then, and why can't it be done in a personal account? Is it a matter of volume?

eastbay

[Paluka]

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There are obviously plenty of professional traders who make money,

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Who make more money than they could have made just riding S&P 500?


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I don't think you understand the difference between trading and investing.

[eastbay]

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There are obviously plenty of professional traders who make money,

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Who make more money than they could have made just riding S&P 500?


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I don't think you understand the difference between trading and investing.

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You're right. I don't see a difference. Maybe you can correct me. Isn't investing one possible (minimal) trading strategy?

In any case if you have X dollars at your disposal, you could trade with it or you could plunk it down in the S&P 500. My question is: do professionals routinely beat the latter with the former?

eastbay

[Paluka]

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You're right. I don't see a difference. Maybe you can correct me. Isn't investing one possible (minimal) trading strategy?

In any case if you have X dollars at your disposal, you could trade with it or you could plunk it down in the S&P 500. My question is: do professionals routinely beat the latter with the former?

eastbay

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These questions don't really make sense. It should be obvious that professional traders get a better return on capital than investing in the S&P, but I don't really think you have any idea what a pro trader on wall street does. How can there be a huge amount of traders employed at banks and hedge funds if they don't get a better return on capital than the S&P.

[gila]

It's fairly easy to beat the game in-itself, the hard part is beating the rake. If you must beat the rake to beat the game, then the in-itself of "beating" the game BECOMES the beating of the game + the rake; so to beat the game to a higher degree, with everything else staying the same, you only need to find lower rake. It is hard to find lower rake than the S&P 500, and thus that much more difficult to beat that game, even if, all other things equal, you are playing better.

[eastbay]

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It should be obvious that professional traders get a better return on capital than investing in the S&P, but I don't really think you have any idea what a pro trader on wall street does.


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Of course I don't. Did you read the OP?

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How can there be a huge amount of traders employed at banks and hedge funds if they don't get a better return on capital than the S&P.

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You're asking my original question back to me.

eastbay

[RacersEdge]

For one thing, investing implies more of a long term strategy. Find a good investment and let it sit and grow.

A trader is trading the assets of the firm to make more money. They do stuff like look at the implied interest rates in a soy bean futures market compared to long term bond yields in Germany. If there is an inconsitency - i.e. I can essentially borrow money at 5% and invest it all at 6%, then I pull the trigger. The opportunity might only be available for a few minutes, but the math models detected it and alerted the traders. Again, I'm not a trader, but that's the basic idea.

[crazy canuck]

I have seen numbers that show that most mutual funds don't beat the S&P 500. This does seem like powerful evidence that an individual investor would have an extremely difficult time beating the S&P 500, since they probably have a day job and don't have the tools available to the professional fund manager.



Mutual fund managers have restrictions that makes it impossible for them to beat the market. Also, it is much harder to generate significant returns with 3 billion than with 10 million. So actually the fact that mutual fund managers perform poorly is not evidence that markets can't be beaten.

I'd say to beat the market is pretty easy if you do your homework, but to beat it significantly and to make a living off it as an individual trader is nearly impossible (unless you have a fairly large capital to start with).

Also, regrading trading there are many types. There is directional trading, derivative trading, market making, arbitrage (and each of these have numerous styles)etc.

[tech]

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True or false?

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False.

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If false, why is this claim made so consistently?

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Most people can't beat the market. Most people are better off just buying an index and holding. But then again, most people can't win 2BB/100 at limit hold 'em. Also, most people can't make a 15% ROI in SNGs, and most people can't win at sports betting. But in each case, there are some people that can. So for your average person, the index fund route is generally the way to go. But there always have been and always will be traders/investors that can outperform the market.

[eastbay]

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True or false?

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False.

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If false, why is this claim made so consistently?

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Most people can't beat the market. Most people are better off just buying an index and holding. But then again, most people can't win 2BB/100 at limit hold 'em. Also, most people can't make a 15% ROI in SNGs, and most people can't win at sports betting. But in each case, there are some people that can. So for your average person, the index fund route is generally the way to go. But there always have been and always will be traders/investors that can outperform the market.

[/ QUOTE ]

Thanks, I figured this was probably the most plausible answer.

I can beat SnGs for several $K a month, and learned to do this within 6 months of playing my first hand of hold 'em. What's that got to do with anything about stocks? Maybe nothing, but maybe something, and I'm trying to learn one way or the other.

The main problem I have with poker as a money making venture is that it is not particularly scalable. The higher you go in stakes, the tougher the games get. With more risk comes less return (proportionally speaking) in general as you move up the stakes ladder. It is self-limiting.

Somewhat like sports betting, investing in markets generally doesn't work this way, as far as I can tell. If you find the opportunity, you can take on more risk for more return by making bigger bets. There is no saturation limit for the individual investor, as far as I can tell. So, I am intrigued by the idea that whatever skills I developed for winning at poker may be, at least in part, transferrable to a new kind of opportunity that is scalable rather than self-limiting.

This is all pure speculation at the moment as I'm (obviously) a complete novice at any of this. But I have read many times (and can see by some examples) that the skills for beating gambling games are applicable to beating the markets. I am trying to figure in what sense and to what degree this is true.

So I'm intrigued and ready to start learning, but I'm not sure where to start. I have read much "popular" literature on investing, motley fool style, and most of it leaves me cold. It is written for people who should buy an index and hold, and probably also should never play poker.

But I'm a poker player and a curious analyst, and I want to learn how to think about the markets beyond "buy an index", but most of what I see passing as analysis seems kind of silly. The language around "technical analysis" seems like 99% hokum. My BS detectors are in full swing when I read about "wave theory" and "support" and "resistance" and "breakout". There's no foundation there. In poker the statistics of the deck provide a foundation and the rest is making good guesses about the people playing the game.

Obviously the dynamics of the market are infinitely more complex than the dynamics of a poker game with 10 players and 52 cards.

But apparently some investors/traders are doing something right, and I suspect they are doing it with at least a semi-analytical approach.

So, what's my next step? Who's doing the real analysis and where do I learn about it?

eastbay

[DesertCat]

[ QUOTE ]
But I'm a poker player and a curious analyst, and I want to learn how to think about the markets beyond "buy an index", but most of what I see passing as analysis seems kind of silly. The language around "technical analysis" seems like 99% hokum. My BS detectors are in full swing when I read about "wave theory" and "support" and "resistance" and "breakout".

eastbay

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You are exactly right. I give little credence to anyone who claims to use technical indicators successfully, most studies show them as hocum.

CrazyCanuck did a great job of explaining why mutual funds don't beat index funds in the aggregate, mainly fees, an awkward structure and too much money to capitalize on small opportunities.

RacersEdge gave a good description of how some professional traders make money. I believe what people call "professional trading" is always arbitrage investing, or trading on informational advantages.

Arbitrage investing means you can essentially find the same thing selling for two different prices, and you make a trade to profit from it. Informational advantages means they have some insight into order flow that others don't.

The most successful long term investors are typically value investors. Ben Graham's books lay out the theory of value investing just like TOP does for poker. Essentially, an investment is worth the stream of cashflows you can reasonably expect from it over time, discounted for time. Discounted for time means that cash the company will get next year is worth less than the same amount of cash on hand, you "discount" it by a reasonable interest rate it would have earned had you the money today.

This is the guide of a very successful group of investors, most importantly, Buffett, but there is a large group of value investors who've beaten the market for decades applying these identical concepts in very different ways. Graham focused on cash heavy companies, Buffett moved onto franchise companies that had very predictable and quantifiable earnings growth.

For example, the leading mutual fund manager today, Bill Miller, uses the same intellectual framework, but applies it to less predictable growth companies than Buffett would. Bill's beat the indexes every year for the last 11 (not sure if he made it last year), an unrivaled record.

Even Peter Lynch, who loved growth companies like Miller does, bought them on a fundamental valuation model.

You can learn this stuff for free by reading Buffett's annual shareholder letters, the last twenty plus years or so are on Berkshire Hathaway Web Site (http://www.berkshirehathaway.com). Ben Graham's Security Analysis and Intelligent Investor are the bibles of value investing, but I have to warn you they are pretty dry reading, and getting very dated. If you can absorb the principles they are well worth it. I think there is a new version of Intelligent Investor that was updated with modern notes and explanations, I'd try that first.

[midas]

Eastbay:

When someone refers to not being able to beat the S&P 500 they are referring to long (hoping for a stock rise) only, equity (stocks) mutal funds which are buy and hold strategies with light trading and no-leverage. Traders who work for Wall Street firms or hedge funds can buy long or sell short (hoping for a decline) anything they want where they think they can make a gain and they can employ tremendous leverage (they can borrow money to invest greater amounts - think home mortgage). These traders can make or lose tremendous amounts of money and go from hero (think yacht, mansions, Red Sox - John Henry) to goat (your fired!!) in a matter of days, remember these guys have a BR of hundreds of millions or even billions to invest. If you're a trader and have a 5 year track record of making 12% or better year after year - the money will find you and soon you too will own your own baseball team. The trick is that when you manage all that $$$ you actually move markets as you invest and it becomes harder to find good investments that generate high ROI. That's why the largest mutual funds like Fidelity Magellan are so mudane because they just can't find many places to invest all that money and wind up basically investing in the S&P 500 stocks.

[tech]

[ QUOTE ]
But I'm a poker player and a curious analyst, and I want to learn how to think about the markets beyond "buy an index", but most of what I see passing as analysis seems kind of silly. The language around "technical analysis" seems like 99% hokum. My BS detectors are in full swing when I read about "wave theory" and "support" and "resistance" and "breakout". There's no foundation there. In poker the statistics of the deck provide a foundation and the rest is making good guesses about the people playing the game.

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Sure, some of that stuff is hogwash, but it is wrong to say that there is no foundation there. Most traditional market theory (like the CAPM, for example) assumes rational and efficient markets and rational market participants. In reality, there are examples on a daily basis that blow this assumption to hell. Technical analysis is rooted more in mass psychology and helps to understand the sometimes collectively irrational behavior of market participants. I personally use a combination of fundamental and technical analysis (primarily fundamental for selection and technical for timing), and it has worked very well for me.

[DesertCat]

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I personally use a combination of fundamental and technical analysis (primarily fundamental for selection and technical for timing), and it has worked very well for me.

[/ QUOTE ]

Let me suggest that your success is rooted more in your skills as a fundamental analyst, than in technical analysis.

No technical analyst seems to be able to pass the simplest test of success, i.e. cutting charts in half and predicting whether the stock went up or down based on the first half of the chart.

I frequently make stunning calls on whether a stock I want to accumulate will go up or down in the next few hours or days. I would think I'm really good at short term predictions if I could only forget the equally many times I was totally wrong. Sometimes people just remember their successes.

The good news is if you are skilled at fundamental analysis, it almost doesn't matter if you mess with technical indicators or not, since they won't matter. You just have to buy when cheap, and sell when expensive.

[Scuba Chuck]

Eastbay, I can't stand reading all the comments to your question, but I'll answer to the best of my ability.

I'll explain four types of traders.

There are market makers. I hope you understand this concept, but briefly, it's an individual (a trader) who takes positions on both sides, and makes his living on the "spread" between the ask and the bid.

Second, there are traders who create unique kinds of opporutnities. For example, they can take large sums of money (hundreds of millions) and create synthetic investment opportunities for small investors. (Example: Owning zero coupon bonds,with leveraged derivatives to give the small investor, very limited downside and a capped upside). There are traders who deal with large block trades, traders who deal with hedging, etc. In fact, John Henry, owner of the Red Sox, runs one of the biggest public managed futures portfolio in the country.

Futures traders. These guys make very huge moneys. In fact, I often wonder why they even offer this product to the individual investor. Their historical success is so unbelievable magnificent, it almost seems like the kind of things they keep close to the vest. Manged Futures is initself a very interesting strategy. I've had more training in this product than most, and I find it very attractive. It's all technical analysis, driven by a constantly changing algorithm. It's all math stuff, things you'd probably find fascinating.

Finally, the trader you're probably thinking about. The typical trader for his own account. Good ones, are generally right about 53-58% of the time (same is true for managed futures traders). There are not many of these. And their profits come in spurts, perhaps just once a year.

[Scuba Chuck]

[ QUOTE ]
But I'm a poker player and a curious analyst, and I want to learn how to think about the markets beyond "buy an index", but most of what I see passing as analysis seems kind of silly. The language around "technical analysis" seems like 99% hokum. My BS detectors are in full swing when I read about "wave theory" and "support" and "resistance" and "breakout". There's no foundation there. In poker the statistics of the deck provide a foundation and the rest is making good guesses about the people playing the game.


[/ QUOTE ]

Technical Analysis, Elliott Wave theory, things I've studied. If you want to read about this kind of stuff, you should begin with the founder. This all begins with Dow Theory. Charles Dow hypoethesized this theory in the late 1890s - early 1900s, and it was carried out by Robert Rhea, editor for the WSJ for the first quarter century of the 1900s. FWIW, I continue to believe in Dow Theory, and read Richard Russell's newsletter (Dow Theory Newsletter).

What's very attractive about dow theory is it's foundation in simplicity. You cannot have a significant move in the Dow Jones Industrial Average without a similar move in the Transportation Average. In otherwords, if the transportation companies aren't busy, then you're in a false economy. Off of this theory, technical analysis was born.

PM me if you have further interest in this topic. But I think reading the book is a good first start. It's more story-like, then textbook. But I am always intrigued how others can study the concepts born from this idea, but have never read this book.

[crazy canuck]

Futures traders. These guys make very huge moneys. In fact, I often wonder why they even offer this product to the individual investor.

Just like in poker 90% of futures traders lose because of transaction cost.

[Rotating Rabbit]

Investment banks are not funds.

The investment banking traders you refer to are mostly functional, trading on behalf of their clients (pension funds etc). The fund manager rings them up and says something like "Jim, get me 500 million of vodafone over the next few weeks when you can" and the traders comply. The trader will have an order book, of what all his clients want to buy/sell and at what conditions, and all day every day he tries to get the best for them. The bank will take a few hundredths of a percent commission.

Why do fund managers trade all the time? Well, everyone has their own targets and their own hopes. Some (hedge funds) believe they have superior analysis tools and look to make a quick profit buying/selling over the period of hours, exploiting small fluctuations in prices. They dont care if a stock has a good future or not, in out like a whippet.

Others (pension funds) are there for the long haul, try to purchase strong stocks, and would keep them for much longer (months/years).

Everyone has degrees of risk too.

There are lots of reasons why people trade, all different.