Tag Archive: Investing

Stock chart showing levels of support (4,5,6, ...

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I plan to write a series of blog entries addressing Market Efficiency, Technical Analysis and Noise Traders. I felt inspired to write this series of entries upon re-reading “ A Non Random Walk Down Wall Street” by Andrew W. Lo and Craig MacKinlay.
Here are a few quotes that I would like you to consider as I work on my next entry:
“Perfectly information ally efficient markets are an impossibility, for if markets are perfectly efficient, the return to gathering information is nil, in which case there would be little reason to trade and markets would eventually collapse. Alternatively, the degree of market inefficiency determines the effort investors are willing to gather and trade on information; hence non-degenerate market equilibrium will arise only when there are sufficient profit opportunities, i.e., inefficiencies, to compensate investors for the cost of trading and information gathering. The profits earned by these industrious investors may be viewed as economic rents that accrue to those willing to engage in such activities.” This quote is attributable to Grossman,S., and J. Stiglitz, 1980, “On the impossibility of Informationally Efficient Markets,” American Economic Review, 70, 393-408.
Who are the providers of these rents?
Black (1986) gives us a provocative answer: noise traders, individuals who trade on what they think is information but is in fact merely noise. More generally, at any time there are always investors who trade for reasons other than informational for example, those with unexpected liquidity needs – and these investors are willing to pay up for the privilege of executing their trades immediately.”
Wikipedia has the following definition for Noise Traders:
A noise trader also known informally as an idiot trader, is described in the literature of financial research as a stock trader whose decisions to buy, sell, or hold are irrational and erratic. The presence of noise traders in financial markets can then cause prices and risk levels to diverge from expected levels even if all other traders are rational.
In finance, noise obtained a formal definition in a 1986 paper by Fischer Black: “Noise in the sense of a large number of small events is often a cause factor much more powerful than a small number of large events can be.”
A more academic definition of a noise trader goes as follows:
Irrational noise traders with erroneous stochastic beliefs both affect prices and earn higher expected returns. The unpredictability of noise traders’ beliefs creates a risk in the price of the asset that deters rational arbitrageurs from aggressively betting against them. As a result, prices can diverge significantly from fundamental values even in the absence of fundamental risk. Moreover, bearing a disproportionate amount of risk that they themselves create enables noise traders to earn a higher expected return than do rational investors.
I will close with a quote from an intellectual giant:
“If the reader interjects that there must surely be large profits to be gained… in the long run by a skilled individual who… purchase[s] investments on the best genuine long-term expectation he can frame, he must be answered… that there are such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate… But we must also add that there are several factors which jeopardize the predominance of such individuals in modern investment markets. Investment based on genuine long-term expectation is so difficult… as to be scarcely practicable. He who attempts it must surely… run greater risks than he who tries to guess better than the crowd how the crowd will behave.”
John Maynard Keynes (1936), p. 157

Cover of "The Black Swan: The Impact of t...

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I am going to touch on a topic that has been made popular over the past few years as a result of the wildly successful book by Nicholas Nassim Taleb “The Black Swan“. I found his  fooled by randomness to be much more interesting, but both are must reads to anyone interested in the market and how we perceive everyday events. The author has a few detractors in finance, academia and the media. You shouldn’t let these deter you from what he has to say as he has yet to  experience the failure that some of his most vocal detractors have.

Nicholas Nassim Taleb must be thought of first as a pursuer of intellectual truth and knowledge, second as a trader and financial commentator. I share with him a desire for independence and freedom from authority and believe that trading can offer that. His most profitable trades have arisen due to misconceptions about risk and chance. Two topics of vital interest to traders.

A “Black Swan” event is the occurrence of a highly improbable event that has extreme implications. Black Swans are the outliers on a data set. If you were to ask where a black swan would show up on a Bell-Curve it would be to the extreme left or right. The two tails of the curve. They are often times the most ignored, yet most important aspects of a data set.  So a black swan trade would be to trade an event that is highly improbable of occurring, but in the case that it does, results in a large or even immense payoff.

The exact opposite of a black swan trade would be to trade an event with a high chance of occurring with a small payoff. An  example of this is given in another great book When Genius Failed by Roger Lowenstein in which he highlights the implosion of Long-Term Capital Management. LTCM was a fund created by some of the most elite and revered names in finance. Their trading style was to find high-probability, low payoff events, leverage the trade by on average 20:1 and hope that the black swan never crossed their path. Well as is often the case in matters of trading, the black swan decided to make its presence known. What resulted wasn’t on the scale our most recent economic crisis, but the fed had to step in with its strong-arm tactics forcing Wall Street’s major players to bail out a group of academic legends.

If you chose to become a black swan trader you will experience bouts of depression and self-doubt as most of your trades end up as losers, if you are able to withstand the psychological assault that this style provides then at the end of the day you will have achieved the independence and freedom from authority that we all pursue. If you chose the LTCM path and many of you will, you will experience a life of satisfaction, but be forewarned that it is a life lived on borrowed time.  For the Black Swan comes swiftly and witthout warning.

Isoalpha isn’t the proper forum for me to offer advice on trades that you should make, my goal is to make you aware of mistakes that can be made. To become a successful trader you have to be aware of your biases and how they affect the decisions you make while trading. You must be willing to look at the data in a different light and constantly question your rationale for making a trade. Just because you can backtest a strategy and found that it has been successful using historical data, doesn’t guarantee that it will be successful tomorrow. It doesn’t mean that you shouldn’t execute it, just be aware of the consequences that will occur if your theory isn’t valid in tomorrows market. If those consequences are bearable then by all means make the trade.