Wednesday, April 04, 2012

Professional Brokers, Retail Buyers and Logic

Logic, epistemology, and scientific evidence don't count for much when you're a professional broker, but they should doubly count if you're a retail buyer.

I have been wondering about the logic of how professional investors buy and sell stocks.  If a professional investor, Mr. A., sells stock #1 and buys stock #2, then Mr. A must think stock #1 will (with a high degree of probability) go down, while stock #2 (with high degree of probability) will go up.  Yet some other investor, Mr. B, must think the opposite of the other guy concerning stock #1, since he bought it, and likewise for stock #2, if he sold it.

Suppose I, a retail consumer, want to get advice on which stocks to buy.  Both Mr. A and Mr. B are professionals.  Yet they would advise me in exactly opposite ways concerning stock #1 and #2!  Since there are always professional buyers and sellers of any given stock in The Big Market everyday, at best I might be following the herd -- i.e., going with what the majority of professional investors are doing.  Is that the winning strategy for a retail consumer like me?

Hardly, and here is the problem:  A study of 10,000 brokerage accounts of individual investors over seven years showed that the average investor does better in selling stocks than in buying them. It is also well documented that the most active traders have the worst results, while those who trade least earn the best returns. [1]

So then, as a retail stock buyer, I am in a very precarious postion, since professionals disagree with one another, and since even they do not do well.  They certainly do well enough to convince retail stock buyers to turn over their money, but not well enough to somehow beat the market based on their (alleged) expertise.  This is why some financial advisers say one should merely buy index funds and ride the general wave of a reasonably expanding market.

I read recently that two out every three mutual funds underperform the market in a given year. Furthermore, most of the big funds that do well are, statistically speaking, only getting lucky and not getting insightful about how the market moves. Naturally, when the luck is holding, they advertise their good returns, and promote a correlation cause fallacy: we analyzed and bought this stock; the stock has been performing well.  Therefore, our analysis and timed buying shows we understand what is causing this stock to perform well. No doubt the vast majority of retails buyers are taken-in by this.  But what seems even more wondrous here is that the professionals seem to believe their own B.S.  Many of them are highly confident that they have some deep, profit-wise reliable intuition about how how stock buying and selling works, yet they have no quantifiable evidence to show this -- i.e., no evidence to separate the above correlation from causation issue about how they happened to have made their money from stocks.[2]

I've been considering buying some stocks lately.  Too bad I have no plan.  But I'm in no worse of a position than anyone else, it seems.  Maybe I'll get lucky.  Actually, it's more rational to think that I won't get lucky, and simply earn about 6% return on my money over the course of many years when taking a buy and hold strategy.



[image] U.S. Dept. of Labor

[1] Terry Odean, Brad Barber "Trading is Hazardous to your Wealth." (.pdf) THE JOURNAL OF FINANCE, VOL. LV, NO. 2, APRIL 2000

[2] Obviously, they know how they make their reliable money -- from trading and management fees.

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