What are the Odds?

Not really sure how to write this… best to start at the beginning and see where it goes. Expect bad writing ahead. In fact give up now!

Had an interesting conversation on Friday on the  subject of dabbling in the stock market. It bought back all sorts of memories of conversation that i used to have during the tech bubble, in my silicon valley days. The general gist of this conversation was that venturing a small (essentially disposable) amount of money the stock market, and making small trades to profit on the intra-day movements of shares was a easy way to make money. The thesis being that it would be possible to expend a period of time learning enough about how the markets work, and profitably use that experience making small trades.

This bothered me… but i struggled (on the right side of several pints of Old Speckled Hen) to articulate why…

The obvious analogy is something like online poker. Surely if its possible to make money playing online poker it must be possible to do the same with stocks. It’s merely a matter of amassing enough information about a specific segment of the market to calculate odds as to whether a particular stock will rise or fall.

On the face of it, this doesn’t seem unreasonable (ignoring the work of people like Stiglitz on information asymmetry). After all, if the markets are reacting to events, and you are aware enough of events to make predictions of the actions of other entities in the market, you should be able to make predictions about individual stocks.

Certainly if you had adopted such a strategy over the long term, for many of the last, say, fifty years you would have profited nicely. Except that those fifty years have been punctuated by massive dislocations that could well have wiped out all your prior gains. This is the story of the turkey in Taleb’s The Black Swan, everyday it gets fed, and if it bases it’s expectation of being fed on it’s prior experience, it’s odds of getting fed improve everyday. This relationship holds through out the year… but the week before Christmas brings an event that is so unlikely that it has become not even worth considering.

Investing for the long term would appear to require less detailed information (but perhaps deeper understanding?), and the introduction of an element of time allows the use of strategies to spread and limit risk, diversifiction, stop-loss, periodically realising gains, etc. There are arguments against things like modelling risk and diversification, but for the investor with the guts to pull the plug and get out, the damage of extraordinary events can be limited. I think.

In the short term (day trading) things seem less clear cut. In essence you are relying on your ability to predict small movements in a market with so many players that it may as well be chaotic. If you aren’t dealing with the kinds of sums of money that can ‘move the market’ you are in essence gambling. There are no doubt situations where the degree to which it is possible to identify winners and losers is so obvious that it’s possible to profit – taking short positions in the banks earlier this year was probably one of them. Their situation was so dire, and the institutional holding that had to be liquidated so huge, that it was very hard to lose in a short bet. And yet, here we are three months later with the market up 30% off it’s lows, one of the biggest rallys in history. How you like to have been caught short when this started? How many were wiped out by margin calls on the way up, and how many will take huge loses on the way back down?

With the number of entities in the market it doesn’t seem likely to me that it’s possible to make any short term predictions with any kind of certainty. What looks like good news to one entity is, bad news to another. Events unrelated to any information available in the market, the machinations of entities with enough capital to move the market  (let alone individual stocks), etc. are completely unpredictable. All attempts to model the likelihood of such events can only really influence decisions that involve an element of time.

Which brings me back around to online poker. The odds of winning at poker, blackjack, etc are knowable. Given enough experience it’s possible to develop a sense of when certain risks are worth taking, and when they aren’t. This contrasts with the situation in the stock market which requires incredibly complex systems of hedging to minimise the risk, while remaining an unknowable problem.

The only way to limit risk (outside of adopting complex hedging strategies, not really accessible to the individual trader) is to play with money that you can completely afford to lose. If you’re taking small positions, and turning them over quickly, your profits are going to be eaten by fees and taxes. 

At this particular time, with the financial system in a state of disarray, and reality continually obfuscated and obscured, it seems a risky business and essentially random game of chance. If i had the time in inclination to spend time in front of the computer gambling, i think i’d stick to poker.

[As i expected this attempt at articulating my current thoughts on investing is a mess. Sorry. Maybe i’ll try and write something more structured another day.]

4 thoughts on “What are the Odds?

  1. don’t apologise its much more eloquent than it was after several pints of old speckled bastard….:-)
    Still think I may have a flutter tho, because as often happens in a game of poker, if all the players are experienced , know the rules, know how to read each other and a complete novice turns up, then often that novice can win (at first at least – back to knowing when to get out) precisely because they do unexpected things and make completely unreasonable gambles.
    That and it looks like fun, chaos is an old friend of mine, I’m sure we’ll get along fine.

  2. I’d go with it if it looks like fun. Wouldn’t count on beginners lucks. Teardrops in the ocean and all that…

  3. It is all essentially gambling. To call economics a science is akin to calling computing a science. It’s a social construct which gives us something to do when we’re not masturbating. And since many social constructs are actually based upon masturbating (computer science was originally coined to mask the desires of men to invent machines to broadcast porn more easily) well we’re at a standstill. As the impeccable Bill Hicks once said:

    The long term odds say that we’re all playing regardless of desire and the shortterm bet looks like you’ll get the clippers out before you finish reading this…

    • i made a joke like that about computer “science” in an interview at google once… to their credit they kept asking me back (after that guy was dead).

      we need a new bill.

Wise words...

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