Riot of

Passive Muffs and Active Goofs

in Financial Markets

The financial markets abound with beguiling myths and wanton mistakes. The two kinds of stumblers – namely, fables and bungles – are distinct as well as entwined. The slew of snags act singly as well as jointly to trip up all manner of investors ranging from rank amateurs to badged professionals.

The multitude of pitfalls may be classified into a couple of broad groups. A myth conveys a false view of the marketplace while a mistake denotes a bum move harmful to the investor. The former is a passive flub while the latter is an active goof.

The two types of spoilers run riot in isolation or combination. For instance, a tall tale may bedevil an investor without giving rise to a costly mistake. On the flip side, a wrackful move could arise in the absence of a slippery myth. In other cases, the two forms of sinkers work together to foil the hapless investor, thus fouling their agenda to varying degrees ranging from patchy losses to complete wipeouts.

From a larger stance, the awesome complexity of the real and financial markets hamstrings any attempt to drum up a cogent program of investment. The actors floundering in the mire run the gamut from dewy-eyed tyros puttering in their spare time to wizen pros plying their trade the whole day long.

Whatever the scope of experience in the field, the mass of participants succumbs to both kinds of muck-ups. As a safeguard, the first task of the canny player is to recognize the welter of hidden traps along with the mordant wounds they inflict. In this treacherous environment, a solid grasp of the myths and mistakes is a basic requirement for avoiding the sinkholes and escaping the minefield.

* * *

In the din and smog of the financial realm, a host of myths and mistakes besets the mass of investors and even leads them to ruin. The two types of bogeys happen to be distinct as well as conjoint. Together the bugbears torment players of all stripes ranging from part-time amateurs to full-time professionals.

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

On the other hand, a myth conveys a flawed view of the marketplace. A rampant example involves the hokum of perfect rationality that holds sway over the mass of academics as well as practitioners. According to the Efficient Market Hypothesis (EMH), every market is an ideal system that makes full use of any trace of information with boundless wisdom and zero delay.

In the larger scheme of things, we could regard a myth as a special type of mistake at a high level of abstraction. In that case, a tall tale would count as a mistaken image of the marketplace.

From a pragmatic stance, however, the two types of mix-ups entail distinct features and impacts. For this reason, we will use the term “mistake” in the narrow sense of a harmful move rather than the broad view of a flawed scheme in general. By this convention, then, a mistake is an active botch in investing while a “myth” is a passive misconception of the marketplace.

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 asserts that the market absorbs every speck of dope with perfect rationality at infinite speed. This fairy tale stands on its own, without a direct link to an active goof by any player in particular.

From the converse stance, a mistake can arise in the absence of a myth. An exemplar lies in the penchant of investors for jumping to the wrong conclusion by adding up the returns on investment in a careless 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?

At this juncture, the bulk of investors would promptly tot up the two payoffs; namely, positive 60% followed by negative 50%. In this way, the eager beavers 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-up is to track the absolute value of the account from one year to the next.

For this purpose, we will consider a small slice of the portfolio. More precisely, we focus on a bitty share whose value at the outset amounts to a single dollar. Since the chit appreciates by 60% over the course of the first year, it swells by 60 cents and thus amounts to $1.60 by the end of the period.

During the second year, though, the same token loses half 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 shrunk to 80% of its initial value at 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 vignette spotlights the fact that adding up the returns on investment is a conceptual flub as well as a pragmatic goof. Yet the bulk of investors rely on the faulty scheme and end up with mistaken views of the performance of motley vehicles ranging from elemental stocks to communal funds.

This and other acts of folly – whether of omission or commission – occur routinely in the circus of finance. A showcase involves the sham claims of lush profits bagged by operators in motley guises ranging from mutual funds and hedge funds to investment coaches and newsletter writers.

The bobble of serial returns spotlights the type of mistake that pops out of nowhere without resting on a fib of any kind. In this and other ways, the gamers in the morass have a custom 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.

From a larger stance, the financial forum is awash with slippy myths that run wild on their own, without any help from the flaky goofs of the investing public. Then there are cases where the two forms of bungling reinforce each other to wreak untold havoc.

Mashup of Passive and Active Goofs

In certain cases, there’s a fine line between a myth and a blunder. An exemplar involves the humbug that an index of the stock market reflects the performance of the average equity over all timespans both long and short. A second and related showcase concerns the mantra of mainstream finance that buying and holding a stock forever is an unbeatable strategy for success.

As it happens, the foregoing pair of myths are tightly twined. In the olden days, back in the middle of the 20th century, a gaggle of academics perched atop ivory towers cast their gaze upon the turmoil in the financial landscape. In an effort to make some sense of the commotion, the spectators watching from afar decided to rummage the data streaming out of the markets. The aim of the pokers was to fish any patterns slinking within the outpour of facts and figures.

Sadly, though, the tribe of scribes was far removed from the hurly-burly of the markets they espied. Not surprisingly, the gazers saw only the superficial features and glossed over the intrinsic aspects of the financial forum as well as the real economy.

To cite an example, the onlookers failed to discern the subtle patterns in the stock market over the short term. An example concerned the day trader who rode fleeting waves in price over the span of a few minutes or hours; or the market maker who lived off the spread between the bid and ask prices of singular stocks from one moment to the next. In these and other ways, a small cadre of professional traders toiling in the trenches managed to earn a living day in and day out.

Meanwhile, on the economic front, the gapers in academe overlooked the fact that companies of all breeds bite the dust in droves. When a firm conks out, one fallout is the rubout of the entirety of stocks, bonds and other securities they happened to issue along the way.

Detached from the scene of the action, the anglers in their laxness 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 efforts to forecast the path of the stock market.

The litany of flops applied just as much to their attempts to pick out promising stocks in the hope of beating the benchmarks of the bourse. Nothing seemed to work, as their chosen candidates failed to outpace the market averages. In short, neither market timing nor stock selection yielded the results they sought.

In pursuing their agenda, the armchair gumshoes took up a basic set of statistical tools in sorting through the deluge of data. Yet the same repertory of techniques was available to the entire world including the hustlers in the trenches ranging from solo traders to communal pools. For instance, many a financial institution maintained a stable of wonks to dredge through the sea of numbers the whole day long in a fervid effort to divine the markets and augur their movements. The legions of analysts thus employed spanned the rainbow from economists and statisticians to engineers and physicists highly versed in quantitative methods.

The tourists in the halls of academe were clearly uncumbered by the weight of common sense, not to mention a load of street smarts. If we look at the big picture, a tool of any sort provides the wielder with a competitive edge only if it happens to be unavailable to the other jousters. If everyone is equipped with the same gear, then no one gains an advantage by dint of the instrument.

As an example, brandishing a knife may confer an edge over an unarmed opponent but not against an adversary who flaunts a similar weapon. In other words, the lack of a commonplace tool poses a disadvantage, but its presence renders no advantage to speak of.

Given this truism, there was no reason to suppose that the casual dabblers diddling on the sidelines could outwit the gung-ho players jostling at center stage by relying solely on a bunch of tools that were widely available to all comers. To presume that such a feat 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 declared that the endless flops they faced 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 beaten under any circumstances. The reason, you see, was that the stock market moved in mysterious ways in an utterly random fashion.

To lend an air of legitimacy, the posers adorned the mumbo jumbo with an epithet hijacked from the venerable field of statistical physics. To wit, the flighty portrait of the market was dubbed the Random Walk Model. Now that the blarney was dressed up as a proven concept from the natural sciences and further garnished with an Ample Dose of Capital Letters, the snow job had to be a respectable result, no?

If the market is the epitome of whimsy, then there’s no point in trying to predict the course of the bourse in general nor the path of any stock in particular. Moreover, a market that can’t be presaged at all lacks any basis for timing the purchase or sale of any asset in a rational way. In that case, another dandy offshoot lies in the futility of trying to outplay the benchmarks of the market.

No one can win the game of investment. The harder you try, the more you lose. Abandon all hope, ye mortal, for persistence is futile.

To bring up another byproduct of the Efficient voodoo, you might as well procure an asset then hold onto it forever. That’s got to be the supreme strategy for success. By holding the widget till kingdom come, you’d reap the maximum gain and bear the minimum cost in terms of time, effort and transaction fees.

In their zeal to cook up a result regardless of its verity, the tellers of tales failed to notice a raft of real properties – both blatant and subtle – within the financial forum as well as the real economy. To point up a counterexample, a fundamental rebuff of ideal markets and evergreen assets involves the fact that an index of the bourse is not what it seems at first sight.

Chasm Between the Real and Ideal

As we noted earlier, death is the way of life for all manner of companies in the real world. What’s more, when a corporation dies off, so does its equity. In the U.S., for instance, the half-life of newborn ventures is merely a couple of years. That is, half of all hatchlings conk out without ever celebrating their third birthday.

Granted, the closure of a business is in some cases a matter of choice rather than fate. An example concerns 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 hulking workload required to launch a venture and nurture the business only to give it all up within a few years. But the wisdom of such a move is in itself an ancillary issue which we will not dwell upon.

More to the point, a successful venture is most unlikely to close its doors and fade away without a whiff of fanfare. Rather, the owner of a viable firm would do much better to sell the company to another party such as a business partner or a competing firm. In this way, the entrepreneur could 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 startups are launched by go-getters spurred by wispy visions of building lusty ventures. All too often, though, the fond hopes are dashed to pieces upon the craggy rocks of reality as countless firms succumb to the rigors of competition in a harsh and unforgiving environment.

Granted, a struggling business might perhaps be acquired by an enterprising person or a corporate wheel. In that case, the equity of the defunct firm could get a new lease on life in a different form. Moreover the same type of transition could occur more than once. In such a sequence, an acquisitive firm is devoured in turn by the next gobbler down the line.

In the fullness of time, though, even the terminal feeder at the top of the food chain will suffer the standard fate of pooping out and dying off. As a result, the faithful investors in the transient outfits along the way – whereby each 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.

Admittedly, a fortunate investor might receive an occasional payout of cash dividends in the interim. Even so, the payments would be paltry or nonexistent during the early stages of upgrowth and expansion for each company; and likewise throughout the shrinkage and collapse of the late phases.

From the standpoint of evolutionary biology, a species can flourish even though each of its members dies out. All that’s required for the culture as a whole to prevail is the absence of a catastrophe that wipes out the entire population in one fell blow.

In a similar way, an index of the market can survive despite the ceaseless rubout of the constituent stocks. In fact, a benchmark may even grind higher while the market at large happens to stagnate or shrivel. For this perverse outcome to ensue, the only requirement is that the band of rising stars covered by the index at each stage should outclass the swarm of falling angels.

If truth be told, the endless process of renewal and upgrowth occurs by design rather than accident. In catering to the financial community, the trustees of the index need to weed out the senile stocks and replace them with youthful ones on a continual basis. Otherwise the benchmark decays over time, loses its mojo, and fades into history. Given the tireless regimen of culling and switch-out, however, the sprightly stocks bolster the yardstick during the zesty portions of their lives before each of the mayflies burns out and dies off in turn.

Despite the uprise of the market benchmarks over the long range, though, the turnout differs entirely for the woeful investor who buys and holds a clutch of shares till doomsday. Doom is the only fate that awaits the die-hard who buys into the buy-and-hold dogma.

In fact the poor sap is headed for the poorhouse at a giddy rate. Given the ferment of technical progress and global commerce in the modern era, along with the upthrows in the financial forum and the real economy, the day of reckoning will likely crop up sooner rather than later. In this turbulent milieu, the buy-and-hold policy is not the triumphant track extolled by the shamans of finance, but rather a sure path to ruin amid the creative destruction of a bustling culture.

At this juncture, we return to the main thrust of this section. The traditional school of financial economics flogs the notion that the motion of the market can’t be predicted nor its performance surpassed. Based on the hoodoo of randomness along with efficiency, the buy-and-hold shtick has been touted as the superlative strategy for investment.

It’s a small step to go from the latter myth to the active goof of actually buying and holding a stock forevermore. In this type of jam, a fuzzy line separates the inert myth from the willful muff. In other words, 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 sum up, a myth is best viewed as a different kind of beast from a mistake. The two forms of bumbling may crop up singly or jointly depending on the context. However, there is in certain cases no difference to speak of between a fable and a fumble.

Wrapup of Mess-ups

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 an active botch.

The two types of stumpers wreak havoc in isolation as well as combination. In the former case, a given snag might trip up the players in the field without any tie-up to the latter form of muck-up; and vice versa. At other times, the myths and muffs work in concert to thwart the unwary gamer, thus fouling their agenda and even driving them to ruin.

If we look at the big picture, the numbing complexity of the real and financial markets hobbles the mass of investors and observers. The actors in a bind run the gamut from clueless newbies dabbling in their spare time to jaded oldsters plying their trade the whole day long.

Whatever the scope of experience in the field, however, the multitude of actors has a custom of tumbling into both types of pitfalls time and time again. On the upside, though, the nimble player can take corrective action to avoid the sinkholes from the outset.

To this end, the first task of the prudent investor is to fathom the multiplex nature of the deadfalls along with the grave losses they inflict. In tackling the din and chaos of the marketplace, a firm grasp of the myths and mistakes leads the way to a sound program of investment.