Fooled by the market
By Robert Moskowitz
Question: I recently saw an article saying that the market ALWAYS moves in a way that makes fools out of a majority of those involved in it. Having recently endured some losses, and failing to get in on some winners, I tend to agree. My question is, why? There are as many buyers as sellers, so why is it a majority that loses?
To answer these questions, we have to understand whether or not a majority of traders DO lose. Only then can we try and puzzle out who might be losers and who winners.
So let’s visualize a simple stock market. The traders/investors include you, me, and that dumb guy over there. Let’s say we all start out with $100. I spend $10 to buy one share of a company. A week later, I offer to sell it at $10. You bid $9.50. That dumb guy bids $10. I sell the share to him. A week later, the dumb guy offers to sell the same share. You bid $8. I bid $7.50. He sells it to you. After another week, you put the same share up for sale again. I bid $8. That dumb guy bids $8.50. He gets it.
So let’s see what happened.
I have $100 and no shares. You have $100.50 and no shares. That dumb guy has only $89.50 and the one share of stock. You’re ahead. I’m even. And the dumb guy – well his relative position depends on how much that one share of stock is valued in the marketplace today.
It seems clear that when stock prices don’t fluctuate very much, every extra dollar a winner takes home must come from some loser’s wallet.
But what happens if stock prices generally go up?
I spend $10 to buy one share of a company. A week later, I offer to sell it at $15. You bid $14.50. That dumb guy bids $15. I sell the share to him. A week later, the dumb guy offers to sell the same share. You bid $20. I bid $19.50. He sells it to you. After another week, you put the same share up for sale again. I bid $25. That dumb guy bids $26. He gets it.
What happened this time around?
I have $105 and no shares. You have $106 and no shares. That dumb guy has only $79 and the one share of stock. You’re ahead. I’m ahead. And the dumb guy – well his relative position still depends on how much that one share of stock is valued in the marketplace today. But if it’s valued at more than $27, he’s ahead of both of us.
Clearly, when stock prices are rising winners can take home extra dollars that no one has to lose. But the reverse is also true: in a falling market everyone can be a loser without anyone being a winner.
When we move from this simple model to the real markets, there are important changes. Most important is that almost every trading day some stocks are going up, some are going down, and still others are staying even. So whether or not you are a winner or loser depends not on the action of whole market, but on which stocks you’re trading, and when.
So far, it doesn’t seem to me that a majority of investors absolutely must come out losers all the time. In fact, during the kind of bull market we’ve been seeing for the past nine years, even that dumb guy can make a fortune. And there’s no mathematical requirement for anyone to be a loser in order to fund the winners.
But there is another important difference between our simple models and the real markets: the importance of detailed and accurate information. The people who know what a particular share of stock is worth today, and what that company’s management is doing to make it worth more or less in the future, can make trades with that dumb guy over there and consistently take advantage of him. He’ll pay top dollar for a glittery stock that the smart traders know is headed down. He’ll sell them stocks that have drifted aimlessly for years, and do it just before a dynamic move upward.
In short, he’ll obligingly transfer money from his wallet to theirs. And he’ll do it consistently, until he gets tired of doing it.
So it seems pretty obvious to me that the losers in the stock market are probably the dumb guys who buy stocks because some guru on the radio mentions the name, or their Aunt Esmerelda recommends it, or all their friends seem to be making money with it, or any one of a thousand dumb reasons. And equally obvious, the winners are probably the ones who know exactly what they are doing, and why.
Since the dumb ones generally outnumber the smart ones in any group, you’re probably right: the market may move in ways that make a majority of traders look like fools. But that’s not the market’s doing. In my view it’s the fools revealing their true natures by betting on long shots and complaining when they don’t turn up.
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Robert Moskowitz is a successful, award-winning writer and consultant, and the author of “How to Organize Your Work and Your Life.”