I love to read books written by efficient market theorists whenever I need a laugh. The works are usually written by an academic with no practical trading experience; these writers confuse the role of chance on a trade-by-trade basis with the edge an accomplished trader creates over a large sample size. From that error, a whole host of errors follow.
Let’s state this upfront: on a trade-by-trade basis, I believe the market is random – given that is driven by human buying and selling.
As an example, take my in-out trade yesterday in the S&P minis (see my video) . When the market failed to cover at least 50% of the gap in the first 60 minutes, the probability was we’d see a trend day closing on its highs. But this is a probability based on a large sample size. Yesterday, the market could just have easily sold off some time after breaking up – it did not have to trend up and did not have to close on its highs. I was lucky that it did. Lucky?
Given that the market on a trade-by-trade basis is random, whenever a trade works out as my analysis suggests it will, I consider it lucky. And because I don’t want the result of any one trade to be skewed towards luck, I practise risk and trade management.
This is the distinction that most academics fail to perceive and understand. The traders who make money consistently, Soros, Tudor Jones, Buffett, Lynch, etc do so partially because of their risk and trade management. Those that blow up, spectacularly (LTCM, Amaranth etc), and those that do so less spectacularly (those among the 90% newbies who fail year after year) have failed to master the lessons of risk and trade management.
In this regard, the newbies are in the same camp as the academics: there is a belief that the world of trading must either provide a reliable forecasting tool or else it is a random walk. In fact, reality lies in the principle that there is a only a probability tool available. And, to guard against the chance that this time, the long-term probabilities won’t work out, successful traders/investors manage their risks and trades.
There is another argument thrown up by the efficient market theorist to counter the many long-term successful traders/investors. It runs something like this:
There are 8192 funds out there. If we have a 50-50 chance of winning in any one year, then we have 4096 funds that will win. If you keep dividing that by two for each year, then say Tudor Jones’ 29 years record falls within the realm of chance.
Wait a moment! That argument fails to account that it’s the same fund that makes money year after year. Since the chance of Tudor making money is not mutually exclusive, you need to multiply the probability of his repeating his success year after year. That number would be very small over Tudor’s 29 years career (see http://en.wikipedia.org/wiki/Paul_Tudor_Jones).
But apart from that, the academics fall into this trap: they assume that all traders are equally capable of making money. Hmmmm. Let’s assume we have 8192 athletes competing for Olympic Gold and let’s say one athlete over 2 Olympics captures the 100m and 200m events. Would we say he is good or just lucky? I know what I would say.
Or let’s take another example – Rocky Marciano: was he lucky that he defeated all challengers given there were 8192 (just a number) boxers all with dreams to be a champion? I’d say he was good not lucky.
So, the markets are not necessarily efficient, and they are not necessarily a random walk. But to succeed you need to take precautions when they are random. The more self-awareness we have of the role of chance, and the more self-aware we are of our make-up, the more likely we are to manage our risks and trades: in short, the more self-aware we are of the role of chance, the more likely we are to be successful.