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Sharemarket Trading - Why the Odds are Against You

 

Every time an investment goes wrong it seems like ASIC are blamed to some extent.  Angry investors ask them why they were not warned.  In the case of sharemarket trading programs and systems ASIC, in information on their website  is clear - if an offer sounds too good to be true then it almost certainly is. 

 

There are plenty of markets to trade in, and trading systems are available for sharemarkets, currency markets, futures markets, contracts for difference (CFD) markets, commodity markets and fixed interest markets.  The basis of most systems lie in 'technical analysis', that is if an investment moves in a particular pattern then it is going to keep moving in that pattern.  The pattern might consider such things as price movements, longer-term trends and trading volumes amongst many other things. 

 

My position on trading systems is pretty simple.  I don't think that they work in the long term.  I don't think that they work in the medium term.  I don't think that they work in the short term.  Other than that I think that they work just fine.  I have never seen any academic evidence to suggest that trading systems work.  I have never met anyone who has made a trading system work over a medium term period, say 2 years or longer.  I have never seen a presentation from a share trading company that makes me think that they work.  My own understanding of investment markets says that they won't work. 

 

There are 5 key arguments I make against these trading programs and their marketing efforts.  These include:

        The 'On Average You Must Lose' Argument

        The 'Don't Forget Dumb Luck' Argument

        The 'Why Would I Share' Argument

        The 'Prove It' Argument

  •    The 'If Your Trading System Works So Well Why Are You Making Money Selling It' Argument

 

In considering using a trading system I have added another couple of sections that I think you should take into account.  These are a reminder about overconfidence and a comment on knowing what your downside risk is.  

 

 

The 'On Average You Must Lose' Argument

 

On every trade there is a buyer and a seller.  They each have opposite views of what will happen in the future.  If I am selling shares than more than likely it is because I don't think that they will perform as well in the future.  The person who is buying those shares disagrees with me; they are buying because they expect the shares to perform well in the future. 

 

So 50% of people lose on every trade.  However that is not the end of it - there are transaction costs to be considered.  It trading is a 50% win/lose proposition before trading costs, then it is going to be worse than that after the costs of trading.  Let us consider a person who trades with $10,000, pays $30 brokerage per trade and has an average holding period of 1 month.  Over the course of the year that person will have made 24 transactions (12 buys and 12 sells) and paid $720 or 7.2% of their starting capital in brokerage.  Some trading systems, particularly around currencies, claim that there is no brokerage.  There is a buy and sell spread, the difference between the buy price and sell price, where the broker makes their money. 

 

Buy wait there's more - the taxman - waiting to reduce your trading profits by up to 48.5%. 

 

Suddenly trading has gone from a 50/50 proposition to a 50/50 proposition less transaction costs and taxes - so on average you have to lose.  That means that the only way you could trade is if you assume that your ?skills' and/or system are above average.  Keep in mind as you consider this that everyone else thinks that they are above average as well - no one trades expecting to lose.  Remember that other traders will include massively resourced hedge funds and institutions with access to far more data and expertise than you will have as you decide whether you are likely to be ?above average' or not.

 

 

The 'Don't Forget Dumb Luck' Argument

 

My experience is that most trading systems seem to market themselves on anecdotal evidence built over very short term trading periods - usually three months.  Their advertising goes something like this - 'Bob is just an ordinary builder who trades for 15 minutes a day and in the last three months made a 38% return'.  Good for Bob!  Usually Bob features in the add with a couple of other successful traders with similar results.

 

So doesn't this add prove that trading systems work?

 

Let us assume that a trading company has 1000 clients.  And let us assume that for every trade a person either makes a 5% profit or a 5% loss.  And let us assume that there is a 50% chance of a person making a profit or a loss - that is a profit or a loss is nothing more than dumb luck.  After the first trade 500 people will have made a 50% profit and 50% a loss.  After the second trade 50% of the 500 people, or 250 will make a second profitable trade.  After the third trade 50% of the 250 will have made another profitable trade - and so on.  The profitability will be due to nothing more than luck, however sheer chance will see some people get lucky a number of times in a row.

 

The statistics after 8 trades are interesting.  4 people will have made 8 consecutive successful trades based on nothing more than luck.  Their return will be 47.75%.  (Remember that there is a compounding effect of getting a 5% return 8 times.  Of those 4 people two will then have another successful trade increasing their return to 55%, one of these going to get a return of 63%.

 

So, let us assume that this trading happens over the course of three months and there is your add.  One return of 63%, two of 55%, one of 47.74%.  All in a three month period!  However these returns are simply luck and a function of a big sample set.  The average return across all traders in our example will be 0%, with some people losing more than 35% of their starting capital. 

 

This example suggests to me why trading systems advertise in this manner.  Focusing on a short term horizon means that simply by chance some people will be successful and focusing on a few anecdotal results ignores the far more important data about what the average return is over the period.

 

 

The 'Why Would I Share' Argument

 

Let us assume that I really did discover a trading system that worked.  For simplicity sake let us say that I discovered that Australian share investments that start with the letter W go down in price on Wednesday and up on Friday.  So you can make a profit by buying shares starting with W on Wednesday and sell on Friday at a profit.  Life is looking OK.

 

Now I have a choice.  I can trade my system and make limitless money.  Or I can package it up and try and sell it to people.

 

What happens if I try to sell it to other people?  Let us say that I sell 1000 copies of my system.  Suddenly, on Wednesday morning there are 1000 people buying shares that begin with the letter W.  The demand for Wesfarmers, Woolies, Westpac Bank and Worley Parsons pushes the price of these shares up.  Then 1000 people sell these shares on Friday, which pushes the price of them down.  Suddenly the extra buyers on Wednesday and the sellers on Friday mean that I can no longer make as big a profit. 

 

This is the major problem with sharing a trading system - if everyone else starts exploiting the trades you want to you will eventually lose your chance to make a profit. 

 

If I ever did discover something like my W trading scheme, I am not going to share it because that will erode my ability to profit from it.  It makes no sense to share the information that provides you with an advantage over the rest of the market!

 

 

The 'If Your Trading System Works So Well Why Are You Making Money Selling It' Argument

 

This argument is not dissimilar to the previous one.  It says that if you discovered a great trading system why go to the trouble of setting up an educational/software company, just trade the system!

 

The complexity and expense that comes with advertising, promoting and distributing a trading systems just does not make sense against the simplicity of trading and earning the above average returns that would come if you had developed a successful trading system.

 

The argument that 'I have already got wealthy from the trading system and I want other Australians to share my success' does not sit well with me.  After all most trading systems are expensive and come with high-pressure sales tactics.  These do not seem to be consistent with the alleged altruistic motive behind sharing a trading system.

 

 

The 'Prove It' Argument

 

Nearly 2 years before I set up my financial planning practice I started planning for it.  One of the first things that I did was get $100,000 and put together a portfolio of investments.  This portfolio was put in place so that I would be able to communicate to investors that I am a competent manager of money.  They would be able to see the style of investments I had chosen, and how they had performed. 

 

If I was selling some sort of trading program that had the ability to produce long term above average returns the first thing I would do would be to establish a long term portfolio that will show over time my ability to generate above average returns.  It will be the simplest and most powerful marketing tool - an actual portfolio showing above average returns over an extended time period.

 

I have never seen such a portfolio. 

 

 

The 'Overconfidence' Reminder

 

Assuming that you can be an above average trader may be a sign of overconfidence.  Overconfidence is a common problem in investment markets that causes people to generate below average results.

 

Some specific examples of overconfidence include:

  • People allocating large portions of their portfolio to a single investment that they are sure will do well, and then having that investment collapse
  • Active professional fund managers who make investment decisions but, on average, fail to outperform a passive index
  • Individuals trading too often, meaning that tax and transaction costs eat into their investment returns
  • Investors trying to 'time' their entry into various investment markets, but ending up missing investment returns due to bad timing.

 

Know the Downside Risk

 

Some trading systems mean that you are taking on highly geared investment positions that, if markets move against you, could cost you more money than you have invested.  It is crucial that you understand exactly the characteristics of the market you are investing in, and the exposure that you have. 

 

A number of trading systems promote stop loss orders as the be all and end all of reducing risk.  However markets can move so quickly that they miss the stop loss point all together.  For example, if you have a stop loss position at $5.00 on shares there is no guarantee that they will trade at this level.  They may have been trading at $5.10 and then drop all the way to $4.80.  It is worth understanding exactly how stop losses work in the trading system you are dealing with.

 

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