Market Trader Forum

Paeda · Anmeldedatum: 02.03.2006 Beiträge: 305

Suppose you had two traders. One--a momentum trader--became optimistic and bought the S&P 500 Index (SPY) every time it rose in price for the day; the other--a contrarian--became optimistic and bought the S&P 500 Index (SPY) every time it declined in price for the day. Each trader held positions three days. What would be their return?

Since January, 1996 (N = 2584 trading days), the momentum trader would have an average return per trade of .01% (725 up, 617 down). The contrarian's average return would be .20% (679 up, 563 down). The trader who bought at the end of *every* day and held three days would have had a return of .10%.

In other words, simply by buying after a down day, the contrarian would have doubled the average return in the market.

By buying after an up day, the momentum trader severely underperformed the market.

Now you know why overconfidence in trading is the greatest pitfall of all. The market is rigged against human nature: getting excited after a rise and discouraged after a decline ensures that traders are on the wrong side of markets.

The Most Common Trading Problem

At a gathering of investment bank trainees in suburban New York last night, I was asked my opinion of the most common problem among traders. My answer was neither fear nor greed. It was overconfidence.

Studies in behavioral finance find that about 3/4 of all traders rate their prowess as "above average", despite the obvious reality that only half of us are better than the other half. This overconfidence, moreover, affects actual trading performance. Research by Terence Odean and colleagues finds that overconfidence affects frequency of trading, which in turn contributes to poor trading results. In one study of online traders, the group of traders favored high beta (volatile) small cap companies and tended to not diversify their portfolios. Their actual trading results slightly beat the small cap index, but after trading costs were factored in, they significantly underperformed the index. The most frequent traders were the ones who underperformed the index by the greatest margin.

One of my favorite studies of overconfidence came from the London Business School. Traders were shown price patterns and asked to figure out the market's next direction and indicate their confidence in their prediction. The price patterns were generated entirely randomly. The traders with the highest confidence in their predictions traded the most frequently and incurred the greatest losses.

A completely random trader--50% right, 50% wrong--who trades once a day will have runs of five consecutive winners about six times during a year. It is difficult to not think you have the hot hand after such a string, become overconfident, and raise your trading size. Of course, the random trader will have an equal number of strings of losers. That is likely to burst confidence and lead the trader to cut trading size--assuming, of course, that he's still in the game at that point.

Is it any wonder that traders seek help from coaches and psychologists? Few of those coaches and psychologists, however, will tell the trader the truth: You're trading random patterns and your problem is overconfidence in them.

Quelle: http://traderfeed.blogspot.com/2006/05/market-is-rigged-against-human-nature.html
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