What evidence would prove the Boglehead mentality wrong?

[VictoriaF]

- active-expert investors suffer from overconfidence.

Victoria,

I agreed with your overall breakdown in your earlier ipost. But now that we're examining the details, the definitions need tweaking.

Expert investors are by definition not overconfident. Egos have no place in trading/investing and good traders/investors are eventually forced to realize that. So I would tweak the definition of experts to account for the fact that most expert investors have, or aspire to have, the type of psychology that includes the mastery of ego issues. Otherwise, they won't be consistently successful.

postingname,

If we define active-expert investors as the ones who can't lose then, by definition, they always win. But this definition is not very helpful for identifying and mitigating issues that even the greatest experts may face. These issues can be considered at two levels:
- psychology and behavioral economics, and
- neuroscience.

In BE, overconfidence is one of the best documented biases, and it's present in both successful and unsuccessful subjects. Kahneman, whose initial insights were developed when he was a psychologist in Israel's military, has a paper about "hawkish" biases of strategic thinking, which is heavily rooted in the Israeli politics.

In neuroscience, there is a well-known winner effect of the escalation of risk taking after every win.

Victoria

[postingname]

So, you don't believe that large profits draw in more competition?

More profits draw in more competition? No, that's not something I normally encounter. Smaller or specialized markets cannot, by definition, accommodate large investors like institutional investors because their trades would have market impact. That keeps a lot of institutions out of the venues where the retail investor has an advantage.

You are confusing the nature of individual humans with the nature of markets.

I have never had success in thinking of markets as abstract entities. The only way markets make sense to me is to think of them as a diverse collection of market participants, each with their own mandates and constraints. In particular, it is institutions that have formal mandates (assigned objectives, precribed asset allocation, etc.) and constraints (governmental constraints, market impact considerations, fiduciary duties, and so on.) Retail investors generally have none of these constraints and can take advantage of other market participants who lack such flexiblity. Viewing a market as an abstract entity doesn't help me as an investor in any actionable way.

[Tanelorn]

If we define active-expert investors as the ones who can't lose then, by definition, they always win. But this definition is not very helpful for identifying and mitigating issues that even the greatest experts may face. These issues can be considered at two levels:
- psychology and behavioral economics, and
- neuroscience.

I think most of the psychology and neuroscience issues are reactions to risk/stress. If you aren't emotionally involved (you don't need the money) and you're good enough that you're likely to win consistently, I think most of these issues stop mattering so much. They mattered along the way to consistency of course. I agree with your post a few back that rising career Sharpe ratios are probably a pretty good way of identifying skill.

[postingname]

HOWEVER,
Even if the trading skill can be identified and isolated, it is counteracted by other neurological factors, such as those creating the winner effect (THBDAW, pp.27-29). As one wins (in a battlefield or in a market), his confidence rises--eventually leading to overconfidence and reckless behavior.

This is well-known among the expert trading community, though perhaps less well-known among the investing community. As touched on earlier, most successful investors/traders do eventually recognize that ego and overconfidence is their worst enemy. The first step in changing the behavior is recognizing it. That's a far easier problem to solve, IMO, than fear, greed, recency bias and some of the other behavioral errors of the naive investor.

[VictoriaF]

If we define active-expert investors as the ones who can't lose then, by definition, they always win. But this definition is not very helpful for identifying and mitigating issues that even the greatest experts may face. These issues can be considered at two levels:
- psychology and behavioral economics, and
- neuroscience.

I think most of the psychology and neuroscience issues are reactions to risk/stress. If you aren't emotionally involved (you don't need the money) and you're good enough that you're likely to win consistently, I think most of these issues stop mattering so much. They mattered along the way to consistency of course. I agree with your post a few back that rising career Sharpe ratios are probably a pretty good way of identifying skill.

I am not an active expert investor. I am a passive investor. My comments about experts are based on my readings, most recently, on reading John Coates's The Hour Between Dog and Wolf (THBDAW). THBDAW has changed my attitude from "one can't beat the market" to "experts can beat the market, with caveats." The credit for the rising Sharpe ratio as an indicator of expertise belongs to Coates; I merely cite him.

The caveats are also not mine but Coates's. He describes several composite trading-floor characters based on the real traders he worked with on the Wall Street and in the City. All these characters are experts. But their performance is strongly influenced by their hormones as well as by the mitigation measures they had or had not implemented well before a downpour has hit the fan.

I think, but do not know, that it's impossible to be an active investor and not to be emotionally involved. All Coates's characters take risk. George Soros admits that when he actively invests his backache provides feedback. Nassim Taleb notes that having a long chain of minor losses punctuated by large gains is psychologically difficult, even when the gains more than compensate for the losses.

Victoria

[postingname]

I think, but do not know, that it's impossible to be an active investor and not to be emotionally involved.

No, that is a wrong generalization. It can apply to some traders, espeically if they are short-term traders. That's because they are constantly engaged in this activity and have little time to decompress. But the longer the timeline, whether investor or trader, the less issues with emotion.

Nassim Taleb notes that having a long chain of minor losses punctuated by large gains is psychologically difficult, even when the gains more than compensate for the losses.

Yes. That would be hard to overcome without a lot of discipline and/or psychological self-evaluation. In some professional settings, an actual psychological counseler is available. But again, these are cases of high-stress trading such as which happens on a trading floor. They are not particularly relevant to an active expert investor.

[VictoriaF]

I think, but do not know, that it's impossible to be an active investor and not to be emotionally involved.

No, that is a wrong generalization. It can apply to some traders, espeically if they are short-term traders. That's because they are constantly engaged in this activity and have little time to decompress. But the longer the timeline, whether investor or trader, the less issues with emotion.

It's a good point. Coates's THBDAW profiles a Wall Street investment bank that has three trading floors: bonds (fixed income), currencies and commodities. Each department consists of flow traders and salespeople. The latter are responsible for convincing various institutions to use the bank's services for their trading; the former are responsible for executing the trades accepted by the salespeople. Flow trading desks, by their nature, must move very quickly.

The situation becomes particularly stressful when markets drop, traders don't want to buy, but are forced to buy by the pressure from their salespeople who want to please bank's large customers that are panic-selling.

Victoria

[Trader Joe]

The best evidence by far would be the overall performance of the Vanguard Healthcare Fund (VGHCX). VGHCX is not an index fund. It is a sector and specialty fund.

VGHCX has a 17.29% average annual performance since 1984. That is a 30 year performance and that is not a misprint. 17.29%!

https://personal.vanguard.com/us/funds/ ... IntExt=INT

[VictoriaF]

The best evidence by far would be the overall performance of the Vanguard Healthcare Fund (VGHCX). VGHCX is not an index fund. It is a sector and specialty fund.

VGHCX has a 17.29% average annual performance since 1984. That is a 30 year performance and that is not a misprint. 17.29%!

https://personal.vanguard.com/us/funds/ ... IntExt=INT

Is this the best evidence that the Boglehead mentality is wrong or that expert investors can beat the market?

Victoria

[postingname]

It's a good point. Coates's THBDAW profiles a Wall Street investment bank that has three trading floors: bonds (fixed income), currencies and commodities. Each department consists of flow traders and salespeople. The latter are responsible for convincing various institutions to use the bank's services for their trading; the former are responsible for executing the trades accepted by the salespeople. Flow trading desks, by their nature, must move very quickly.

The situation becomes particularly stressful when markets drop, traders don't want to buy, but are forced to buy by the pressure from their salespeople who want to please bank's large customers that are panic-selling.

Interesting. I wouldn't have thought the flow traders would have much stress since they're dealing with customer money. Proprietary traders, on the other hand, are trading the company's money -- using their own discretion. A lot of ego involved there and emotion, if not kept in check.

Here is an amusing post -- amusing mostly because of the style and spelling, which I had to correct a bit for readability -- by a student who wants to get into trading at an investment bank. He asks a lot of good questions.

As everyone here I suppose already know the difference between a flow trader and a prop is that a prop trader trades the company's money whereas a flow trader just executes the trade on behalf of the customer. Thats why we see that all them big bonuses actually go to proprietary traders. Why? Because they are the guys that make the decision whether to execute a trade or not.so its fair that someone who takes the potential risk to also take the potential profits. Flow traders (90-95% of total traders in a bank) on the other hand execute whatever the guy on the phone tells them to. They only make money through arbitrage opportunities. My question for those guys that are working in the Trading divison of any IB is:

If a flow trader's job is to EXECUTE whatever the sales team/customers on the phone tells them to, then WHY do IBs want people from the best unis/quant degree and so on. It seems to me that ANYONE could do that. As long as u are mainly the guy that pushes the BUY/SELL button on that computer, whats the big deal about it. Its not ur money therefore u dont need to do analysis/research for a certain stock. As I said. u are the direct executant of different orders. There is no responsability on ur side whether a stock is going down or up, u are not responsiblle for any of that.

This all seems to be WAY TOO EASY. Is there any catch?

I can understand why they would want top notch people in their prop division cause they are the ones that are making the call and its their responsability whether they are making money or losing money. That who takes the risk shall also take the loss/profit.

Note that the post is old -- from 2007. Prop trading has supposedly been taken out of the banks as a result of new regulations.

[tadamsmar]

Are these experts capable of teaching others? Can they set up a kind or industrial process based on scientific and engineering principles to efficiently capture the available profits?

Are is this a more, shall we say, esoteric expertise? Expertise developed by some kind of ineffable technique.

[VictoriaF]

It's a good point. Coates's THBDAW profiles a Wall Street investment bank that has three trading floors: bonds (fixed income), currencies and commodities. Each department consists of flow traders and salespeople. The latter are responsible for convincing various institutions to use the bank's services for their trading; the former are responsible for executing the trades accepted by the salespeople. Flow trading desks, by their nature, must move very quickly.

The situation becomes particularly stressful when markets drop, traders don't want to buy, but are forced to buy by the pressure from their salespeople who want to please bank's large customers that are panic-selling.

Interesting. I wouldn't have thought the flow traders would have much stress since they're dealing with customer money. Proprietary traders, on the other hand, are trading the company's money -- using their own discretion. A lot of ego involved there and emotion, if not kept in check.

Here is an amusing post -- amusing mostly because of the style and spelling, which I had to correct a bit for readability -- by a student who wants to get into trading at an investment bank. He asks a lot of good questions.

As everyone here I suppose already know the difference between a flow trader and a prop is that a prop trader trades the company's money whereas a flow trader just executes the trade on behalf of the customer. Thats why we see that all them big bonuses actually go to proprietary traders. Why? Because they are the guys that make the decision whether to execute a trade or not.so its fair that someone who takes the potential risk to also take the potential profits. Flow traders (90-95% of total traders in a bank) on the other hand execute whatever the guy on the phone tells them to. They only make money through arbitrage opportunities. My question for those guys that are working in the Trading divison of any IB is:

If a flow trader's job is to EXECUTE whatever the sales team/customers on the phone tells them to, then WHY do IBs want people from the best unis/quant degree and so on. It seems to me that ANYONE could do that. As long as u are mainly the guy that pushes the BUY/SELL button on that computer, whats the big deal about it. Its not ur money therefore u dont need to do analysis/research for a certain stock. As I said. u are the direct executant of different orders. There is no responsability on ur side whether a stock is going down or up, u are not responsiblle for any of that.

This all seems to be WAY TOO EASY. Is there any catch?

I can understand why they would want top notch people in their prop division cause they are the ones that are making the call and its their responsability whether they are making money or losing money. That who takes the risk shall also take the loss/profit.

Note that the post is old -- from 2007. Prop trading has supposedly been taken out of the banks as a result of new regulations.

The following factors contribute to the complexity of flow trading:
1. A client works with several banks and plays them against each other. A salesperson asks a flow trader about the price at which he could sell some client's bonds. if the flow trader responds with a price that's too low, the client will use another bank, the salesperson will be mad at the trader and next time will give business to someone else.

2. A client wants to unload a large amount of bonds, and the flow trader has to sell them piecemeal.

3. A flow trader wants to hold down to some client's shares instead of selling them immediately, because he expects the price to rise.

4. During a market decline, clients call salespeople, and salespeople put pressure on flow traders to buy securities from clients, even if the traders would have preferred to do nothing.

THBDAW does not mention proprietary traders ("props") but it describes two traders from the arbitration desk ("arbs") who seem similar to props. Arbs are "rocket scientists" that do not work with the bank's clients but provide liquidity for the bank itself and heavily speculate using their models. In the book, it is the arbs rather than the flow traders that dramatically fail when the market turns around.

Victoria

[Johno]

Johno, I have a bit of trouble deciphering what you are saying. It's a matter of termnology, posting style, format and so on. Basically, I'm having trouble finding the main points you're making. I'm hoping my 80%/20% guestimate given above helps explain what I think and helps address what you may or may not be saying.

If you admit that the BH mentality would work better for 80% of people who are now active investors, which is essentially what you just said, then I don't understand *your* point on a basic logical level, forget about phrasing or style. Why are you commenting in any way in the direction of 'BH mentality proved wrong', if you think it would work better for 80% of active investors than what they do now?

Isn't it kind of to tell us how *you're* a special person who beats the market? I say it with all due respect. Again, any extremist supposed BH'er who says *nobody* can consistently beat the market is obviously wrong, so it's a straw man argument to say the BH mentality, properly defined, is proven wrong by the small % of individual investors who consistently beat the market. And it was a pointless exchange when an earlier poster challenged you to 'prove' you beat the market. If you do, don't, convince yourself you do with selective recollection, no really really do, rigorously counting everything and consistently so for a long time... it's not that relevant to the real point. Once we agree only a small %* of active individual investors beat index funds (in otherwise similar financial asset trading/investment), we've agreed the BH mentality, properly defined, is *right*, insofar as any such simple set of rules for a complex world can be 'right' (the rules work for the great majority). We haven't gotten anywhere toward answering how it could be proved wrong.

*I believe think it's much less than 20%, of non-professional individuals *consistently* beating index funds in similar investing, but let's not quibble, say it's 20.