Because the markets are so efficient, the market doesn’t punish you much for being wrong
Could you explain this cause-effect a bit more? My intuition says if I make the wrong choice where the vast majority is making the right choice, my losses will quickly get snapped up into everyone else’s gains
Turn the question around: assume your goal is to lose money. If a market was 100% efficient, the price moves would be 100% unpredictable, i.e. random. You’re just as likely to make money as to lose it trading such a market. How could you lose money if you tried? Think about it.
I can only think of a few ways.
The first, obvious, way is to trade a lot. You lose commissions and spread each time you trade. Even if some of your trades happen to make a lot of money, you can lose more by overtrading. How quickly this happens depends on the size of the spread and commissions, and the frequency of your trades. You lose more slowly this way if you trade less often. Hence, DON’T PANIC.
The second way is leverage. If 100% of your portfolio value is within the expected move of your trade, then you stand to make a lot of money on the upside, but you lose everything on the downside. Even if you happen to start in a winning streak, you are almost certain to eventually lose it all. But 100% is not required. As long as you’re over the Kelly fraction, you’ll lose the entire bankroll eventually. Hence, Don’t Bet the Farm.
The third way is more subtle. Even assuming an efficient market, the buy-and-hold strategy can work over time due to the risk premium. The random walk has a negative skew with a positive drift. You’ll hit a few home runs when the market crashes, but, over the long term, a short-and-hold strategy will lose money. Hence, Don’t Fight the Wave.
I can think of numerous individual strategies for losing money, but they all seem to fall into one of these three categories, assuming an efficient market.
There is a fourth way to lose money trading, but it breaks one of our assumptions: trade in an inefficient market. Alpha is difficult to find. You’re probably no more likely to stumble upon a negative alpha trade than a positive one. Find some alpha, and then make the opposite bet.
I thought of a few more. Taxes, fees, and penalties can cost you. Be especially careful about mutual funds, which can charge outrageous amounts in an attempt to keep you locked in. One can avoid a lot of taxes by using retirement accounts, but you really can’t take the other side of these deals.
Inflation is another big one. You’re not technically losing anything in nominal terms, but your buying power does shrink over time. The Fed’s 2% target is not such a big deal for one making 20%, but sometimes inflation is much higher.
Bear market risk is fairly easy to understand: a rapid selloff decreases the value of stocks you own; in which case one is better off holding cash or commodities. That’s left-tail risk. OTM puts are left-tail insurance.
Right-tail risk is less intuitive. After all, if your stocks rapidly appreciate, isn’t that a good thing? But a period of high inflation can also inflate stock prices, although the relationship is complicated (value stocks tend to do better, while growth stocks may be hurt by the economic effects of inflation by more than their prices inflate). Inflation is a Red Queen race: you have to run (in dollar terms) just to hold your position (in buying power terms). In a period of higher inflation, one has to run faster to keep up. OTM calls are right-tail insurance (there is also a sense in which they’re equivalent to a married put). Commodities (but not cash) can also be helpful here.
Even without high inflation, missing out on the right tail can mean being left behind compared to a non-dollar benchmark, like passive index investing. Hence the buy-and-hold adage about time in the market rather than timing the market. However, cutting off both tails would have done similarly well, at least historically. You can theoretically do that with a costless options collar, i.e., sell a covered call to fund an OTM (married) put, although IV skewness across strikes makes that less obviously a win as the downside has to be further OTM. Using (e.g.) VIX calls as insurance may be more efficient, but it’s also more complicated.
Could you explain this cause-effect a bit more? My intuition says if I make the wrong choice where the vast majority is making the right choice, my losses will quickly get snapped up into everyone else’s gains
Turn the question around: assume your goal is to lose money. If a market was 100% efficient, the price moves would be 100% unpredictable, i.e. random. You’re just as likely to make money as to lose it trading such a market. How could you lose money if you tried? Think about it.
I can only think of a few ways.
The first, obvious, way is to trade a lot. You lose commissions and spread each time you trade. Even if some of your trades happen to make a lot of money, you can lose more by overtrading. How quickly this happens depends on the size of the spread and commissions, and the frequency of your trades. You lose more slowly this way if you trade less often. Hence, DON’T PANIC.
The second way is leverage. If 100% of your portfolio value is within the expected move of your trade, then you stand to make a lot of money on the upside, but you lose everything on the downside. Even if you happen to start in a winning streak, you are almost certain to eventually lose it all. But 100% is not required. As long as you’re over the Kelly fraction, you’ll lose the entire bankroll eventually. Hence, Don’t Bet the Farm.
The third way is more subtle. Even assuming an efficient market, the buy-and-hold strategy can work over time due to the risk premium. The random walk has a negative skew with a positive drift. You’ll hit a few home runs when the market crashes, but, over the long term, a short-and-hold strategy will lose money. Hence, Don’t Fight the Wave.
I can think of numerous individual strategies for losing money, but they all seem to fall into one of these three categories, assuming an efficient market.
There is a fourth way to lose money trading, but it breaks one of our assumptions: trade in an inefficient market. Alpha is difficult to find. You’re probably no more likely to stumble upon a negative alpha trade than a positive one. Find some alpha, and then make the opposite bet.
I thought of a few more. Taxes, fees, and penalties can cost you. Be especially careful about mutual funds, which can charge outrageous amounts in an attempt to keep you locked in. One can avoid a lot of taxes by using retirement accounts, but you really can’t take the other side of these deals.
Inflation is another big one. You’re not technically losing anything in nominal terms, but your buying power does shrink over time. The Fed’s 2% target is not such a big deal for one making 20%, but sometimes inflation is much higher.
Bear market risk is fairly easy to understand: a rapid selloff decreases the value of stocks you own; in which case one is better off holding cash or commodities. That’s left-tail risk. OTM puts are left-tail insurance.
Right-tail risk is less intuitive. After all, if your stocks rapidly appreciate, isn’t that a good thing? But a period of high inflation can also inflate stock prices, although the relationship is complicated (value stocks tend to do better, while growth stocks may be hurt by the economic effects of inflation by more than their prices inflate). Inflation is a Red Queen race: you have to run (in dollar terms) just to hold your position (in buying power terms). In a period of higher inflation, one has to run faster to keep up. OTM calls are right-tail insurance (there is also a sense in which they’re equivalent to a married put). Commodities (but not cash) can also be helpful here.
Even without high inflation, missing out on the right tail can mean being left behind compared to a non-dollar benchmark, like passive index investing. Hence the buy-and-hold adage about time in the market rather than timing the market. However, cutting off both tails would have done similarly well, at least historically. You can theoretically do that with a costless options collar, i.e., sell a covered call to fund an OTM (married) put, although IV skewness across strikes makes that less obviously a win as the downside has to be further OTM. Using (e.g.) VIX calls as insurance may be more efficient, but it’s also more complicated.
Thanks, this is very valuable. I’ll have to think about this some more; I don’t think I’ve internalized it enough yet: