Myths versus Mistakes

Riot of
Passive Muffs and Active Goofs
in Financial Markets

Image of a nasty dragon
The financial markets abound with beguiling myths and wanton mistakes. The two kinds of muffs – namely, fables and bungles – happen to be distinct as well as jumbled. Together the stumpers trip up all manner of players ranging from rank amateurs to badged professionals.

A myth is a false view of the marketplace while a mistake is a bum move that whops the investor. The former is a passive flub while the latter is an active goof.

The two kinds of spoilers can play out their roles in isolation or combination. As an example, a tall tale may bedevil an investor without giving rise to a costly mistake. By the same token, a bad move could arise in the absence of a sly myth. In other cases, the two modes of bungling work in concert to thwart the heedless actor, thus fouling their agenda even to the point of ruin.

From a larger stance, the immense complexity of the financial forum and the real economy crimps any effort to drum up a cogent program of investment. The players stuck in the mire run the gamut from wide-eyed greenhorns puttering around in their spare time to wizen veterans plying their trade the whole day long.

Whatever the scope of experience in the field, the bulk of participants fall prey to both types of muck-ups. As a countermove, the first task of the shrewd gamer is to recognize the plethora of stumbling blocks along with the nasty wounds they inflict. In breaking free of the minefield, a solid grasp of the myths and mistakes paves the way for building up a trenchant program of investment.

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In the chaos of the financial markets, a slew of myths and mistakes torment the mass of investors and even lead them to ruin. The two types of bloopers happen to be distinct as well as intertwined. Together the bugbears harry players of all stripes ranging from part-time tyros to full-time pros.

In this context, a mistake refers to a faulty move by an actor in the marketplace. An example involves a punter who leaps on a bandwagon at the height of a bubble or dumps an asset in the depth of a panic.

By contrast, a myth conveys a flawed view of the marketplace. A case in point is the hokum of perfect order in the stock market. According to the Efficient Market Hypothesis (EMH), the bourse is an ideal system that makes full use of every scrap of information with boundless wisdom and zero delay.

At a high level of abstraction, we could regard a myth as a special type of mistake. In that case, a tall tale happens to be a mistaken image of the marketplace.

From a practical stance, however, the two kinds of muffs exhibit distinct features and effects. For this reason, we will use the term “mistake” in the narrow sense of a harmful move rather than the broad scope of a flawed scheme in general. According to this convention, then, a mistake is a headlong goof in investing while a myth is an inert misconception of the market.

Independence of Myths and Mistakes

A myth can stand by itself without reference to a mistake of any sort. In the example given above, the false creed of utter efficiency declares that the market absorbs every piece of dope with perfect rationality at infinite speed. This fairy tale stands on its own, without any direct link to an active flub by anyone in particular.

From the converse stance, a mistake can crop up in the absence of a myth. A glaring sample lies in the widespread habit of investors of jumping to the wrong conclusion after adding up the returns on investment in a mindless fashion.

To bring up a simple example, consider a portfolio that racks up a profit of 60% within the span of a single year. After the windfall, however, the account loses half its value over the course of the second year.

Under these conditions, what was the overall return on investment during the entire stretch of two years? Without further ado, the bulk of investors are wont to sum up the two payoffs; namely, positive 60% followed by negative 50%. In this way, the plungers come to believe that the portfolio clinched a net profit of 10% from start to finish.

Upon closer inspection, though, the truth lies in the opposite direction. A plain way to grasp the nature of the botch is to examine the changes in the absolute value of the account from one year to the next.

For this purpose, we will consider a small slice of the portfolio. In particular, we could think of a bitty stake whose initial value amounts to a single dollar. Since the snippet expands by 60% over the course of the first year, its value grows by 60 cents and thus swells to $1.60 by the end of the period.

During the second year, though, the same sliver loses half of its value. In that case, the foregoing figure shrinks by one-half; after adjusting for the cutdown, the stake is now worth only 80 cents.

In this way, each dollar of principal at the outset has shriveled to 80% of its initial value by the end of the two-year stretch. The actual loss of 20% over the entire span stands in stark contrast to the fancied gain of 10% reckoned by the mass of investors.

This cameo spotlights the fact that adding up the returns on investment is a conceptual flub as well as a pragmatic goof. Yet many an investor relies on the faulty scheme and ends up with misleading views of the performance of sundry vehicles ranging from individual stocks to communal funds.

Here is an example where a mistake occurs on its own without standing on a fable of any kind. In this and other ways, the actors in the marketplace have a habit of tripping over their own feet without even stepping into the sea of bunk spewed out by the canons of orthodox theory and popular folklore.

More generally, the financial forum is awash with slippery myths that hold sway on their own, without any help from the proactive flubs of the investing public. Then there are cases in which the two types of mess-ups work in concert to reinforce each other.

Mashup of Passive and Active Goofs

In certain cases, there’s a fine line between a myth and a mistake. An exemplar lies in the humbug that an index of the stock market represents the performance of the average equity over all timespans both long and short. Another showcase involves the mantra of mainstream finance that buying and holding a stock forever is an unbeatable strategy.

As it happens, the foregoing pair of myths are closely conjoined. In the olden days, back in the summer of the 20th century, a gaggle of academics perched atop ivory towers cast their gaze upon the hubbub of the financial patch. In an effort to make some sense of the commotion, the spectators watching from afar decided to rummage the data streaming out of the marketplace. The aim of the pokers was to pick out any patterns lurking within the murky swirl of facts and figures.

Unfortunately, the band of scribes were far removed from the hurly-burly of the markets they espied. As a result, the gazers glossed over the reality of the financial forum as well as the real economy.

To bring up an example, the onlookers failed to discern the subtle patterns in the marketplace by which a troupe of professional traders in the trenches managed to earn their living day in and day out. Moreover, on the economic front, the gapers overlooked the fact that companies of all breeds bite the dust in droves, thus resulting in the rubout of the stocks, bonds and other securities that were issued along the way.

Detached from the scene of the action, the sifters could not make head or tail of the mounds of data they screened. For instance, the probers tried and failed time and time again in their attempts to forecast the course of the stock market.

The litany of flops applied just as much to their efforts to pick out nifty stocks in the hope of beating the benchmarks of the bourse. Nothing seemed to work, and their chosen entries failed to outpace the market averages.

In pursuing their agenda, the armchair gumshoes took up a basic palette of statistical tools to scour the mounds of data. Yet the same techniques were available to the entire field of questers ranging from solo traders to communal pools. In fact, many a financial institution had a custom of hiring scores of specialists to crunch the same trove of numbers the whole day long in an effort to divine the markets and foretell their movements. The legions of analysts thus employed spanned the rainbow from economists and statisticians to engineers and physicists highly versed in quantitative methods.

Apparently, the tourists in the halls of academe lacked a dash of street smarts. To wit, a tool provides its wielder with a competitive advantage only if it happens to be unavailable to the other contenders. If everyone is equipped likewise, then no one has the upper hand by dint of the aid.

For instance, brandishing a knife may confer an edge over an unarmed opponent but not against an adversary who flaunts a similiar weapon. In other words, the lack of a commonplace tool results in a disadvantage, but its uptake provides no advantage at all.

Given this snip of common sense, there was no reason to suppose that the casual dabblers diddling on the sidelines would be able to trounce the mass of serious players at center stage by relying solely on a bunch of tools which were readily available to all comers. To presume that the woozy goal lay within their reach was to call their judgment into question.

As the years of fruitless effort turned into decades, the dredgers of data were still loath to give up and admit defeat. Instead the spin doctors proclaimed that the repeated flops they encountered were no flubs at all. According to the party line, the plethora of letdowns merely served to show that the market can’t be predicted at all, nor the benchmarks trumped under any circumstances. The reason, you see, was that stock market moved in mysterious ways in a purely random fashion.

To lend an air of legitimacy, the spoof was adorned with an epithet snatched from the venerable field of statistical physics. The flighty portrait of the market was dubbed the Random Walk Model. There you have it: if the hooey has been primped with an esoteric title – especially one that’s abstruse or convoluted – then it’s got to be a respectable result, no?

Since the market is supposed to be the epitome of whimsy, there’s no point in trying to predict the course of the bourse in general nor the path of any stock in particular. In addition, a market which can’t be presaged at all lacks any basis for timing the purchase of a stock in a rational way. In that case, another corollary lies in the futility of trying to outwit the benchmarks of the market.

Ergo, you might as well procure a batch of equity then hold onto it forever. And that, ladies and gentlemen, has got to be the supreme strategy for sucess in the field: namely, the path to maximum gain braced by minimum cost in terms of time, effort and transaction costs.

In their zeal to cook up a result, however specious, the eager beavers failed to notice scads of germane features – both blatant and subtle – about the financial forum as well as the real economy. To pick an example, a rebuff lies in the fact that an index of the market is not what it seems at first sight.

As we noted earlier, death is the way of life for companies of all breeds in the world at large. What’s more, when a corporation goes under, so does its equity.

In the case of the U.S., for instance, the half-life of newborn ventures is merely a couple of years. That is, around half of all hatchlings die out without ever celebrating their third birthday.

Granted, the shutdown of a business is in some cases a matter of choice rather than fate. An example involves an entrepreneur who decides to go into retirement after a couple of years in business.

To bring up a counterpoint, though, one could question the sanity of a self-starter who takes on the gross workload required to launch a venture and nurture the business only to give it all up in short order. But the wisdom of such a move is in itself an ancillary issue which we will forgo here.

More to the point, a successful venture is most unlikely to close its doors and fade away without a whiff of fanfare. Instead the owner of a viable concern would do much better to sell the company to somone else, as in the case of a business partner or a competing firm. By this means, the entrepreneur may reap a handsome reward for their labors to date.

On the whole, then, it seems fair to regard the death of a business as a sign of failure rather than a mark of success. Millions of ventures are launched by live wires fired up by vivid visions of building up lusty ventures. All too often, though, the fond hopes are dashed to pieces upon the craggy rocks of reality as hordes of startups succumb to the rigors of competition in a harsh and unforgiving environment.

On occasion, a struggling business might be acquired by a corporate buyer. In that case, the equity of the defunct outfit could get a new lease on life by morphing into the shares of the gobbling firm.

Moreover the same type of transformation could crop up more than once. In this sequence, one company is devoured by the next gobbler down the line.

In the fullness of time, however, even the terminal firm will suffer the standard fate of the enterprise by breaking down and going bust. In that case, the faithful holders of the interim shares during the relay race – where one company gives way to the next – will end up holding an empty bag, with nothing to show for the rocky ride they endured along the way.

From the standpoint of evolutionary biology, a species can flourish even if each of its members dies out. All that’s required for the culture to prevail is the absence of a calamity that wipes out the entire population at a single stroke.

In a similar way, an index of the market can survive in spite of the continual wipeout of the constituent stocks. In fact, a yardstick may even grind higher while the market as a whole happens to be stagnant or shrinking. For this perverse outcome to ensue, the only requirement is that the band of rising stocks covered by the index should outweigh the throng of tumbling shares during the window of appraisal before each of the widgets duly breaks down and bows out in turn.

Despite the silver lining for the market in its entirety, the turnout differs entirely for the hapless investor who buys and holds a clump of shares till doomsday. Doom is the only fate that awaits the die-hard who buys into the buy-hold dogma.

In fact the poor sap may well head for the poorhouse with frightful speed. Given the ferment of technology and globalization in the modern era, along with the upthrows in the financial forum and the real economy, the day of reckoning will likely come around sooner rather than later. In this raucous environment, the buy-hold policy is not the triumphant course extolled by the shamans of finance, but rather a sure path to damnation due to the facts of life.

At this juncture, we return to the main thrust of this section. The traditional school of financial economics flogs the notion that the movement of the market can’t be predicted nor its performance surpassed. As a byproduct of the random model and the efficiency voodoo, the buy-hold policy has been held up as a superlative ploy for the investor.

It’s a small step to go from the latter myth to the woeful muff of actually buying and holding a stock till kingdom come. In this type of jam, a fuzzy line separates the inert myth from the active mistake. Put another way, the two modes of bungling are for the most part one and the same. We could say that the pair of flubs comprise two sides of the same coin.

To recap, a myth is best viewed as a different kind of beast from a mistake. Moreover the two forms of bungling may crop up separately or jointly depending on the context. Meanwhile, there is in some cases no difference to speak of between a fable and a bungle.

Wrapup of Bloopers

To round up, a myth is a false view of the marketplace while a mistake is a bum move that hurts the investor. The former is a passive flub while the latter is a headlong goof.

The two types of bogies can wreak havoc in isolation or combination. In the former case, a given snag might trip up the actors in the arena without any tie-up to the other type of muff. At other times, the myths and mistakes work in concert to stymie the unwary player, thus mucking up their agenda and even driving them to ruin.

Looking at the big picture, the pother of the real and financial markets fuddles the mass of investors. The players in a daze run the gamut from clueless tyros flailing around in their spare time to seasoned oldsters plying their trade the whole day long.

Whatever the scope of experience in the field, however, the vast majority falls prey to both types of bungles. On the upside, though, the nimble player can take corrective action to pull free of the quagmire.

To this end, the first task of the agile mind is to recognize the multiplex nature of the hang-ups along with the galling losses they entail. In the din and smog of the marketplace, a firm grasp of the myths and mistakes that run riot in the field sets the stage for fixing up a sturdy program of investment.