Dice

Committing Financial Suicide

Dice
"The way I like to think of day trading is that it's probably the most effective weapon ever to commit financial suicide," Zweig stressed. "It's an absolutely lethal way for the typical person to invest because it's not even really a form of investing, it's gambling pure and simple." (source)

– Jason Zweig, NY Times Columnist

The lure to actively trade in the stock market is all around us. It does not take more than five minutes of flipping through TV channels, reading financial periodicals or magazines, or surfing the web to find at least one advertisement begging us to take action with our money. And, why wouldn’t we? It’s only part of our human nature to look for a quick advantage to reposition ourselves within our existence. A past IFA article explained the paradox of how we are just not hardwired to be excellent money managers. Las Vegas is the perfect social experiment of this very point.

As with gambling at the Bellagio, actively playing in the stock market can be a very expensive way to learn a hard lesson. The hot stock tips that our neighbor told us are usually less successful than flipping a fair coin (this is because stocks are traded at fair prices). Even the vast majority of the best and brightest (better referred to as the luckiest) within our industry fail to consistently turn their daily efforts into something that is more rewarding than the “average” returns delivered through index funds. However, gambling will never go away nor will the continuous effort to “get rich quick by cheating risk,” at least not until humans cease to exist.

A 2012 paper entitled “Trading as Gambling,” further concluded that investors are constantly looking for quick payoffs, and are even substituting one type of gambling for another depending on the size of the reward. Based on two distinct samples of retail investors within the United States and Germany the authors concluded that, “in both data sets, variation in lottery prizes explains variation in retail trading. Bigger lottery prizes are significantly related to reduced trading activities, indicating that stock traders substituted their trading activities to focus on winning large sums of money in the lottery.” 

This should come to no surprise, and in all honesty I personally do not have a problem with it. I do gamble when I go to Vegas and I even have a little fun putting money down at the local racetrack, but I think of my expected losses as a payment for having fun. I know the odds are stacked against me since most casinos are still doing just fine, as are most companies that provide stock trading brokerage firms with remarkable revenues. I may win every once in a while, but as Louis Bachelier forcefully stated in his Theory of Speculation: The Origins of Modern Finance, the expected value of engaging in a trading activity is zero and even negative after costs are accounted for. I may beat the house or pick the winning horse, but my expectation is that I will not be able to repeat this performance the more I decide to play the game. Or stated another way, luck does not persist.

I believe this to be the key difference between how investors approach the lottery and how they approach actively trading in the stock market. Most people know the odds are very low of winning the lottery. Unfortunately, the same humility is not present when people are actively trading their investment portfolio. They truly believe that they have the next best idea that nobody else is aware of and that they have more information than the combined knowledge of millions of other traders. Academic literature has refuted this notion over and over again (Odean, 1999; Lee, Liu, and Odean 2009; Barber and Odean 2002; Dorn and Sengmueller 2009), but investors still decide to partake with far more than what they would be willing to risk in other gambling situations.

Humans are hard wired to make predictions and bet on them and that is not going to change, which will keep the lights flashing in Vegas, the seats full in racetracks and the phones ringing in brokerage firms. Active trading and gambling activities release adrenaline and endorphins. These chemicals can produce feelings of euphoria even when you’re losing money. In turn, this encourages addictive personalities to take bad positions, just to get the rush (source). This is why Mark Hebner subtitled his "Index Funds" book "The 12-Step Recovery Program for Active Investors." If you haven't read it, you are missing out on understanding the clear linkage between gambling and the stock market trading and far better ways to build your financial security.