Stock Trading Is (Literally) a Bigger Gamble than Poker
Merely beating the average for 10 years makes you a superstar …
One of the largest studies of stock trading was carried out through the 1990s and early 2000s by Brad Barber of UC Davis and Terry Odean of UC Berkeley. Millions of trades pointed to one conclusion — it’s all a giant crapshoot.
Odean and Barber focused on individual investors. Examining the trades in some 10,000 brokerage accounts, they found that “on average, the shares that individual traders sold did better than those they bought, by a very substantial margin: 3.2 percentage points per year, above and beyond the significant costs of executing the two trades”. (Kahneman, 2011) They later analyzed the trades of more than 70,000 investor households across 6 years, and found they underperformed the market by 1.5 points, translating to an 8% loss versus index funds. (Barber & Odean, 2000)
There were two big reasons why the individual traders lost:
- They tended to sell to “lock in” a win after a price rise, even though recent winners have a better chance of performing well in the near future than do recent losers. In other words, they sold too early.
- They tended to buy stocks that were in the news, even in cases when the newsworthy event would tend to move the price down (e.g., being in particular situations for mergers or buyouts). In other words, they bought too often at the start of a down trend.
But hey, you’re going to pay a pro to help you, and they don’t make those mistakes, right? True enough, but in order to earn their keep they have to outperform the market plus your fees, otherwise you’re better off buying some index funds and forgetting about it. And guess what? The market literally is these same people — professional investors. So the only way it can possibly make sense for you start trading rather than riding the index is if you can find a pro who is significantly more skilled than the majority of other traders, and keeps the fees lower than their positive margin against the market.
So how do the professionals fare?
Well, during the 1990s other researchers were looking at the pros. For them, they measured the “persistence of individual differences”. So what does that mean?
Imagine you get together with friends for a coin-flipping competition. The results of each match are totally random. Still, everyone will have winning streaks and losing streaks just by pure chance as the game progresses. A few of these will be remarkable, like a series of a dozen tails in a row, and people will get excited about them. But if you play for a long time, everyone’s win-lose ratio will end up being pretty much the same. There is no persistence of individual differences.
Now compare that to, say, professional sports. There, you find that top players consistently have superior win-lose ratios across the arc of their career. It’s what makes them top players. Serena Williams doesn’t have equally long winning streaks and losing streaks interspersed among periods of middling play. She dominates the sport for years, with some ups and downs of course, because she’s better.
The same turns out to be true for the game of poker. The ranks of top players are significantly stable over time. Daniel Negreanu isn’t luckier than the vast majority of players, he’s better than they are. (And if you know the game, you can tell that by watching him play.) That’s why U.S. courts have ruled that poker is a game of skill rather than chance. And that’s why there are no professional craps players, although I’m sure there are professional craps coaches out there somewhere.
So what did the trade histories reveal? “The evidence from more than fifty years of research is conclusive: The selection of stocks is more like rolling dice than playing poker. The year-to-year correlation between outcomes is barely higher than zero. Nearly all stock pickers, whether they know it or not — and few of them do — are playing a game of chance.” (Kahneman)
That said, the pros really do have access to useful information and they really do have the hard-earned skills to analyze that information and make better trades than the amateurs. So why can’t they outperform the market (which is to say, themselves)?
Well, it’s because all that information and all that analysis turns out to be useless. Here’s why….
You can’t know what you can’t know
There are three types of information regarding stocks:
- What you know that everyone else knows — This is information which you can safely assume has already been factored into the current market price of the stock, such as the contents of last year’s annual report.
- What you know that nobody else knows — This is “inside information” which is usually illegal to act on, and which in any case no trader can possibly have for any significant number of trades within a sizeable portfolio.
- What you know that you don’t know whether other traders know — This is information, and conclusions drawn from that information, which a significant number of other traders may or may not possess, or may or may not have yet factored into the price of the stock. This is the “skill” side.
Information in the first two categories can effectively be ignored. So the “skill” of outperforming “the market” — which is to say, the field of traders itself — lies in category three, figuring out angles that other traders haven’t figured out.
The problem with that sort of knowledge is precisely that, short of developing omniscience or at least a global case of ESP, it is literally impossible for any trader to know whether or not a significant number of other traders have or have not come to the same conclusion already and factored that into the market price of the stock. In other words, it’s impossible for any trader to know whether their own analysis is or isn’t “baked into” the current stock price. And without that critical piece of knowledge, it becomes a crap shoot. “Unfortunately, skill in evaluating the business prospects of a firm is not sufficient for successful stock trading, where the key question is whether the information about the firm is already incorporated into the price.” (Kahneman) The small positive tilt in the findings can be explained by the certain inevitable percentage of trades made with category-2 insider information.
So, why is it that stock traders can’t hone their skills like poker players can? There are two prime factors that determine whether “judgments reflect true expertise”:
An environment that is sufficiently regular to be predictable
An opportunity to learn these regularities through prolonged practice
“Stock pickers operate in a zero-validity environment. Their failures reflect the basic unpredictability of the events that they try to forecast…. Intuition cannot be trusted in the absence of regularities in the environment.” (Kahneman).
Just look at all the unpredicted events that have had profound effects on stock markets — 9/11, the Great Recession, the covid pandemic, the outbreak of the Great War, the Dust Bowl and stock market crash of the late 1920s, the rise of the Internet and digital trading, and on and on. Add to that all the smaller yet equally unforeseen events that have rocked individual stock prices or stock sectors, like the Enron scandal or the VW emissions scandal. Every eventuality can be explained in hindsight. But the fact is, there is no way to “learn” an inherently unpredictable feedback system like the stock market. In fact, it’s regularity-proof, because any predictive means, once known, becomes factored in and thereby loses its own predictive value. By contrast, poker odds are unwaveringly regular, and there are certain constants of human biology, and therefore human behavior, that can also be learned through practice. So players who can quickly and accurately calculate their odds on the fly, and who learn to “read” other players correctly by observing their betting patterns and their mannerisms, will consistently outperform those who are less skilled at both tasks.
Then how do traders get on magazine covers?
But what about superstar traders? They can’t be doing that well by blind chance, can they?
Turns out, the question we need to ask is how many of them there are. Since they’re superstar traders, we know there aren’t that many, or else they wouldn’t be superstars. Then we need to ask, how many traders are there in the market?
Here’s a case history from Leonard Mlodinow’s The Drunkard’s Walk: How Randomness Rules Our Lives:
If you look long enough, you’re bound to find someone who, through sheer luck, really has made startlingly successful predictions. Consider the case of Leonard Koppett, who revealed a system that he claimed could determine, by the end of January every year, whether the stock market would go up or down in that calendar year. It worked for eleven straight years, from 1979 through 1989, got it wrong in 1990, and was correct again every year until 1998. His system was based on the results of the Super Bowl. Whenever the team from the NFL won, the stock market, he predicted, would rise. Whenever the team from the AFL won, he predicted, the market would go down. Had he had different credentials — and not revealed his method — he could have been hailed as the most clever analyst since Charles H. Dow.
Consider now the story of Bill Miller, sole portfolio manager of Legg Mason Value Trust Fund. In each year of his fifteen-year streak his fund beat the Standard & Poor’s 500. For his accomplishments, Miller was heralded “the Greatest Money Manager of the 1990s” by Money magazine, the “Fund Manager of the Decade” by Morningstar, and one of the top thirty most influential people in investing in 2001, 2003, 2004, 2005, and 2006 by Smart Money.
The odds that by chance some manager in the last four decades would beat the market each year for some period of fifteen years or longer is almost 3 out of 4. I would say that if no one had achieved a streak like Miller’s, you could have legitimately complained that all those highly paid managers were performing worse than they would have by blind chance.
In other words, statistically speaking — which is to say, objectively speaking — the very fact that Miller’s achievement is as rare as it is indicates that it is the result of random chance rather than skill. In fact, Miller himself remarked that “the so-called streak [is] an accident of the calendar. If the year ended on different months it wouldn’t be there and at some point the mathematics will hit us. We’ve been lucky. Well, maybe it’s not 100% luck — maybe 95% luck.” Indeed, by the summer of 2017, Money was reporting “Lessons from the downfall of legendary stockpicker Bill Miller”, and fessing up that “even the best stockpickers fail to consistently beat the market.”
If stock trading were a skill, we would expect that a top tier of traders would exist which remained fairly stable over the period of a decade and a half, with some old hands moving out and a few newcomers rising up. Instead, one single trader who manages such a streak is an eye-popping anomaly — and all he did was to beat the average! It’s like our coin-tossing competition, where everyone gawks at the dozen tails in a row.
Does this mean you shouldn’t invest? No, of course not. It just means that you’re likely to pay more in fees than you earn if you trade with a pro versus indexing, and you’re highly likely to lose if you do it yourself. But that doesn’t mean you won’t get your money’s worth from, say, index funds or a fee-only wealth manager or financial advisor, who will have a legal fiduciary duty to you and will look at investments along with taxes, insurance, your home, and everything else. They’re completely different services, and there are other options as well.
If you do find yourself tempted to get into stock trading, just remember… every trade is a roll of the dice. And they make you pay to roll, too.
Barber & Odean (2000). Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. Journal of Finance, 55, 773–806.
Barber & Odean (2006). Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment. Quarterly Journal of Economics, 1116, 261–92.
Barber & Odean (2008). All That Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors. Review of Financial Studies, 21, 785–818.
Barber, Odean, et al (2009). Just How Much Do Individual Investors Lose by Trading? Review of Financial Studies, 22, 609–32.
Grinblatt & Titman (1992). The Persistence of Mutual Fund Performance. Journal of Finance, 42, 1977–84.
Elton et al (1997). The Persistence of Risk-Adjusted Mutual Fund Performance. Journal of Business, 52, 1–33.
Elton et al (1993). Efficiency with Costly Information: A Re-Interpretation of Evidence from Managed Portfolios. Review of Financial Studies, 6, 1–21.
Kahneman (2011). Thinking, Fast and Slow (Farrar, Straus and Giroux), 212–16.
Mlodinow (2008). The Drunkard’s Walk: How Randomness Rules Our Lives (Random House), 177–81.
Koppett, Leonard. Carrying Statistics to Extremes. Sporting News, 11 February 1978.
Header image via Wikimedia Commons