I had a paper route as a kid. It was an evening paper, which meant that I made my deliveries after school. One of my first stops was a barber shop that fronted for a bookmaking operation. Even as a kid I could see that something was off because there were always a bunch of men sitting around in the afternoon without getting haircuts and the barber/owner had two telephones.
Naturally, I wanted to get in on the action, but the proprietor (wisely) never even acknowledged that there was gambling on the premises. However, he did agree to allow me to bet on the area football team’s game each week (the Buffalo Bills) for his subscription. If I picked the game right, he paid double and, if I missed, he got a free paper. I generally won, but I suspect he considered it a loss leader for future business.
Most people conceive of trading in a similar way. The idea is to pick winners. And they’re right to a point, but only to a point. You see, whenever I’d get cocky about my winning record, my bookie would remind me that I wasn’t picking against the spread — I was picking outright. Because stocks have prices, trading isn’t really about picking outright winners. It’s like picking against the spread.
That’s the basic point that index advocates make with respect to beating the market. They say that the market immediately prices in all information related to a stock’s value so that it’s impossible to win overall “against the spread.” That’s false, of course, because the market is not a weighing machine — rationally weighing intrinsic value via price — it’s a voting machine — reflecting popularity decisions about stocks, which can be wildly irrational.
A fallback position of index advocates is that the irrational judgments of individuals somehow add up to rationality, in a sort of Wisdom of Crowds effect. But as these experiments show, crowds can lead to big mistakes and perversely give their members false confidence at the same time on account of social influence. Moreover, a new study suggests that markets become more unstable and prone to bubbles precisely as they move closer to the ideal of information efficiency. Finally, game theory helps clarify optimal (rational!) behaviors in simple strategic games, but it becomes largely irrelevant in complex games — many agents with many strategies (like markets). In that setting, as this study shows, dynamical systems theory offers far more insight into system dynamics. We aren’t terribly rational much of the time.
The academic points outlined above are probably better made by another gambling example. An old trader friend from New York got his start (of a sort) in trading by gambling in college. This was in the days before cell phones and on-line gaming. My friend would work a gambling arbitrage (subject to serious counterparty risk) by betting against the home team with a nearby bookie and against the visiting team with a bookie in the visiting team’s city to take advantage of the wide diversity of point spreads. As with stock prices, point spreads do not reflect an objective assessment of the relative strengths of teams. Rather, they reflect the betting habits of bettors and thus the irrational hopes and fears of fans. Optimism bias is never more prevalent than among fans of sports teams.
None of this is to suggest that it’s easy to beat the market or to beat point spread with any consistency and persistency. But as any bookie willing to share will tell you, spreads are made not to reflect the relative strength of the teams but, instead, to balance out the bets on each team. Trading is no more rational than gambling.