Thursday, July 20, 2017

The Dangers of Personifying the Stock Market

Most people understand that the stock market reflects the collective actions of all stock traders, but we often personify the market, talking about it as though it has its own free will. This can lead to investing errors.

When we say that “stock markets struggled this week,” we don’t literally mean that there exists some sentient entity called the “market” that has the desire to rise, but was unable to do so this week. But thinking of it this way can create the illusion that you have only a single foe when you trade stocks.

It can also create the illusion that we can all somehow succeed against the market. When someone says that some past market event was easily predictable, such as the 8-year recovery from the 2008-2009 crash, many would agree. But it can’t be true. If we all knew stocks would rise so much, then buyers would have driven prices up right away.

When we see the stock market as the collective action of all buyers and sellers, it becomes clear that there had to be a lot of uncertainty among traders 8 years ago because stock prices just rose slowly instead of jumping all the way back up immediately. In fact, we must always be in a state where most traders are uncertain, because, if they weren’t, stock prices always shift up or down until they were uncertain.

If you’re trying to beat the market by getting higher than market returns, your real opponents are all the other stock traders, not just some single entity. Traders can’t all be winners. For every dollar of market outperformance, there has to be a dollar of underperformance.

So, when you try to beat the market, you have to ask yourself whose trading dollars you expect to take. Even worse, because almost all trading is done by professional investors these days, you need to ask yourself which investment pros’ dollars you expect to take.

None of this proves that you can’t beat the market. But it does show that the deck is stacked against anyone who tries, particularly after factoring in the costs associated with trying to beat the market.

4 comments:

  1. Is the market always rational? Are market prices rational?

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    1. @Anonymous: The answers to your questions are no and usually. But the average dollar trying to exploit irrational prices fails to do so.

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  2. That also points to why market participants have different goals. It's very possible for professional traders to be selling an asset because they're worried about how it will look on their quarterly reports, at the same time that you think it's a good price to buy because you want to own it for the next 30 years.

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    1. @Richard: You point out one of many reasons why a professional might make a potentially exploitable trade. But the typical investor who tries to exploit such mistakes will fail in the attempt.

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