Tuesday, November 30, 2010

The Right Mindset for Trading Equities

For many people it’s almost impossible not to have opinions about stocks. Even those who use a low-cost indexing approach to investing like me find themselves with a strong opinion about a company’s prospects from time to time. For those who commit real money to their opinions, I have a suggested mindset for trading.

Imagine an office building with 1000 people working away on clusters of the latest powerful computers. The workers are former physicists. String theory wasn’t challenging enough for them and they went looking for greater mathematical challenges. Now they are all working together developing advanced trading strategies.

The next time you trade an equity imagine these former physicists being on the other side of the trade selling whatever you’re buying or buying whatever you’re selling. I’m not saying this just to scare readers; this is a fairly accurate depiction of the trading universe.

I’m a believer in owning equities and taking some investment risks, but trading frequently against multiple armies of former physicists is dangerous. I prefer investment strategies that require very little trading.

6 comments:

  1. Don't happen to know if any of those buildings are looking for another almost-physicist, do you? ;)

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  2. Yes, I also get the feeling that as a small time investor, I'm not playing on a level field against super computers, and professional traders.

    But don't discount the reality that these super computers and army of geniuses had been frequently wrong, EPIC WRONG.

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  3. You make a good point. When you trade you are buying and selling from and to people who many times have more information than you.
    Just as an FYI: trading stocks is fun because it is a challenge and it is exciting to pick winners. Therefore I let my clients trade up to 20% of their portfolio assets. Still 80%, i.e. the bulk of their retirement assets are kept indexed along the lines you suggest.

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  4. @Potato: I was courted briefly by a firm looking for quants. Because I wasn't very interested I didn't find out much about what qualities they look for in prospects. You may have to get a few high-profile papers published before the head-hunters come knocking :-)

    @P2Sam: If I had to guess I'd say that the physicists get trades wrong about half the time. This would be because most of the time they are trading against each other. They might get a slight boost when they trade against retail investors.

    @Sandy: It sounds like you want me to publish an advertisement for your web site as genuine content on my blog. I don't think this is the sort of thing that my readers would want to see.

    @DIY Investor: Using a losing strategy with 20% is better than 100%, but I prefer to find my excitement elsewhere. I sympathize with the near impossibility of convincing certain people that they can't pick individual stocks successfully. The majority of such stock pickers never even look at a company's financial statements. Yet they can't be convinced that their strong opinions are just random. I rarely even try to convince these people any more.

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  5. Meir Statman asks traders to frame their bets in exactly the same way. He also says trading is not like hitting tennis balls against a practice wall. It is more like playing tennis against more skilled players on the other side who are hidden from your view.

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  6. @CC: Statman's book sounds interesting. The reviews I've seen have him explaining that people get emotional benefits from their poor investing strategies. What I can't tell is the degree to which Statman thinks that this behaviour is rational. I guess I'll have to read the book.

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