Monday, June 6, 2011

Market Predictions Encourage Risky Investing

A quote I saw in a recent covered call article got me thinking. Rob Carrick quoted Eden Rahim, who was speaking about a particular Horizons covered call ETF product:

“If you’re a super bull and think the market is going to advance vertically, this product is not for you ... If you think the market is going to do something other than advance vertically, as it has in the past couple of years, then this is something to consider.”

This way of thinking about investing feeds two types of magical thinking. (And to be clear, I’m not accusing either Carrick or Rahim of magical thinking.) The first is more obviously silly when exposed: the market can only have one outcome at a time. It can’t “advance vertically” for me but do something else for other people. If two people have opposite market guesses, at least one will be wrong.

The second type of magical thinking is that we can somehow know what the market will do with certainty. The market will rise, drop, or stay the same with some probabilities. It’s conceivable that some people may have better insight into the probabilities, but nobody can rule out some of the outcomes with certainty.

This means that an investor who thinks the market will go up and makes a large bet on this guess without thinking of the consequences if he or she is wrong may be taking on undue risk. Investors should always be thinking about what will happen if the market moves against them.

This carries over into other areas as well. Homeowners would do well to consider how their finances will handle it if house prices triple or get cut in half over the next decade. We’re most likely to have an outcome in between, but we must consider the full range of possibilities.


  1. Agree.

    But just as people do not read the fine print in contracts they sign, neither will they be bothered with the details of investing.

    Like lemmings, they follow the advice handed to them by the so-called experts who fleece the sheep by taking commissions off the top.

    Neither your broker nor your real estate agent care about you and your purchase. Just as long as you buy something.

  2. I haven't found directional trading to be the best approach myself. I prefer range trading strategies that also have the ability to accept adjustments for price risk. These have worked much better for me. Better to be there to take advantage of one option certainty - time decay. I love it!

  3. @Mark: I agree that there are problems, and that solving them is at best daunting and at worst hopeless. But I'm not concerned with saving the world; I just want to improve my little corner of it :-)

    @Owen: I don't have any experience with the trading strategy you're following, but if I were to try it I would always evaluate the effect on my finances if my guesses were completely wrong and the market moved hard against me.

  4. Great post.

    Nobody can be right all of the time. I think some folks are about to get severely fleeced by these covered-call ETFs.

    I'm not going near these things.