How to Become Smarter (50 page)

In theory, it would make sense to recommend everyone to start a business if we were living under a utopian economic system such as the following. In that economy 50% or more of the labor force are self-employed, and tiny companies, four people or fewer, employ the majority of workers in the economy. This means that small enterprises do not have to grow in order to survive and that most people who start their own business succeed. Therefore, self-employment is a rule rather than an exception, and you have a realistic chance of becoming your own boss. This hypothetical system will have to severely restrict industrial concentration, that is, mergers, acquisitions, and growth of the number of employees of a company. The laws and regulations under the “self-employed system” will have to encourage creation of small businesses and sole proprietorships instead of creation of jobs. Large companies can often produce things at a lower cost compared to small companies (what is known as “economy of scale”). Thus, the self-employed system will be less efficient than the current economic systems of industrial countries. It is also politically unfeasible. Economies of scale are one of the reasons that make it difficult for small businesses to compete against large corporations. The self-employed economic system will have to make economies of scale disadvantageous through some policies. This will probably slow down technological progress and economic growth in general. My guess is that this utopian system will be motivated by individual financial independence rather than consumerism.

The advice against investing in your own startup is valid in most cases, but there are exceptions. One example is someone who has rich parents and can try many different ventures before he or she finds something that works. Another possible exception is when venture capitalists are thrilled about your business idea. There may be other rare situations when investing in your own startup company will be justified. Just keep in mind that for a person living in the United States who does not have a self-employed parent, the probability of successful self-employment outside the agricultural sector is approximately one-eighth. You can find a lot of useful information on the
website
of the U.S. Small Business Administration, even if you do not live in the United States.

In conclusion, it is worth discussing why it is a horrible idea to quit your job before you have a successful business or before you find a new job. It doesn’t matter if you have savings that will allow you to not work for a while. With rarest exceptions, you should always find a new job before quitting the old one. This must be obvious to most readers, who can
skip ahead
. Impulsivity often causes a person to leave a job (see an
earlier section
regarding how to reduce impulsivity). Many employers view people without a job as damaged goods and prefer to give a new job to an employed person. (Strange isn’t it? You will get a new job only if you don’t really need it.) Why is a person between jobs so unattractive to prospective employers? Because there are several unappealing possibilities:

1. the jobless person doesn’t get along with coworkers;
   
2. the jobless person is a lazy or clumsy employee and got fired as a result;
   
3. the jobless person is insubordinate;
   
4. the jobless person isn’t very smart because he or she quit the old job before finding a new (and better) one.
   

From the standpoint of an employer, it is always safer and more advantageous to hire a person who already has a job. This is why you are unlikely to find a better job if you quit first and then start looking. If you hate or dislike your boss, this feeling is normal (very common) and you need to accept this harsh reality. Don’t try to punish your boss by quitting your job because you will punish yourself more. The rare situation when quitting your job before finding a new one would be smart is when something blatantly illegal is going on, you are filing a big lawsuit (sexual harassment, embezzlement, accounting fraud, and the like), and your lawyer has advised you to quit your job.

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You must have seen advertisements on TV or on the Internet that invite you to trade stocks or currencies (or other financial instruments) from home. This supposedly will allow you to earn additional income or even to quit your day job. These ads often feature fictional characters, such as self-employed traders, who are making tons of money by trading in financial markets from the comfort of their home. You may have also met people in internet chat rooms or on message boards who claim that they are making a living by trading. There is little research data to either support or refute the advertising claims of brokers/dealers or day trading firms. It is difficult to find any hard data on statistics of success or failure of traders. From what little that I could find though, the general conclusion is that only a minority of traders (10% or less) can make a living and the majority of traders lose money. This is not surprising because trading is a zero-sum game where the profits of one player must come from the losses of another. On top of that, trading involves substantial transaction costs (bid/ask spread and commissions), which further reduce the numbers of winners and increase the percentage of losers. We can conclude that trading will be a waste of time and money for the great majority of participants. My advice is to avoid it because the chance of success in this occupation is 10% or less.

In my view, it is convenient to subdivide trading into:

• day trading (holding periods from 1 minute to 12 hours),
  
• position trading (holding periods from 12 hours to one month),
  
• speculation (holding periods from one month to one year).
  

We will review each of them below. Day trading involves quick buying and selling of the same stock (or another type of financial instrument) within a day. Day traders close all open positions at the end of a business day and can make five or more trades per day. A complete trade can involve buying low and selling high or short selling high and then buying low. There are day trading firms that provide clients with direct access to electronic trading systems such as SOES and Island ECN. This access can result in lower transaction costs and improved order execution speed for a day trader of equities. There are restrictions on day trading of stocks in the United States. According to the Securities and Exchange Commission (S.E.C.) regulations, a person who wants to day trade must have at least $25,000 in his or her brokerage account. There are no restrictions on day trading of most other financial instruments, such as futures and foreign exchange.

Three studies published in the last 8 years shed light on this controversial activity. One study, by Douglas J. Jordan and J. David Diltz, examined trading records of 324 day traders of NASDAQ stocks for the 1998-1999 period [
512
]. The average duration of a trading record was about four and a half months, and each trading record included over 300 complete trades, on average (buy-sell or short-buy). Careful statistical analysis of these data led the authors to make several observations. About 64% of day traders were unprofitable and sustained losses. About 35% of day traders made money or broke even (after we take transaction costs into account). Fourteen percent of day traders made more than $10,000 during the examined period (4.5 months on average). These data suggest that those people can make a living, although taxes and living expenses will consume most of the profits. About 7% of traders made more than $20,000, suggesting that this percentage of people can make a living and expand their trading business at the same time. It is unclear what the average size of the account was in each of these groups of day traders.

Statistical analysis showed that about 50% of the profits and losses of day traders were the result of movements of the NASDAQ index [
512
]. Most day traders prefer “long” transactions (buy low and sell high) over “short” transactions (sell high and then buy low). Therefore, these traders, on average, tend to have profits when the index goes up and to sustain losses when the NASDAQ declines.

Another study, by Brad M. Barber and colleagues, examined trading records of all day traders in Taiwan over a five-year period from 1995 through 1999 [
511
]. These authors observed similar results, namely that the majority of day traders, 80% in this study, lost money within any given 6-month period. The performance of profitable day traders is not random and successful day traders continue to make profits. The most active day traders (by total volume of transactions) are also the most profitable. About 10% of all day traders can make annualized profits greater than or equal to 66% of an average salary in Taiwan. This observation suggests that fewer than 10% of day traders can make a living in this data set. Even fewer can grow their day trading capital, if we take into account taxes and living expenses.

The third study, by Ryan Garvey and Anthony Murphy, examined the behavior of 15 successful day traders for the three-month period in 2000 and analyzed over 95,000 transactions on NASDAQ by these people [
524
]. The authors found that successful day traders are active only during the most liquid market hours. Those day traders are also able to update their quotes faster than NASDAQ market makers and thereby can steal business from these influential market participants. The traders examined in this study can gauge direction of the price of a stock based on quote updates of NASDAQ market makers. The day traders may also use some other information, such as trading volume, chart patterns, and the news. The successful day traders place limit orders within the best available quotes of market makers and are able to exploit the momentum of price movements. This is surprising because day traders have a significant informational disadvantage compared to market makers. Market makers have access to order flow information and can make small profits consistently because they can always see if the supply is greater than demand or vice versa for any given stock. Day traders do not have access to this information, yet they are often able to update their quotes faster than the NASDAQ market makers. In conclusion, this third report supports the findings of the other two studies above, that a minority of day traders can be consistently profitable. Due to the large number of transactions of day traders in these studies, the results are significant statistically and could not have occurred by chance.

These data contradict the well-known “random walk hypothesis.” The random walk hypothesis postulates that stock prices are random and unpredictable. Therefore, a trader cannot profit consistently from publicly available information such as a price chart, trading volume, and news items, according to this theory. In my opinion, the random walk hypothesis is applicable to position trading and speculation as defined above (holding periods from 12 hours to one year). It does not apply to extremely short-term movements of stock prices (day trading). There are several possible reasons.

One reason is that day trading involves a lot of daily effort, and day trading profits are by no means “easy money.” Longer-term trading (for example, several times a week or several times per month) is almost effortless; therefore, competition will eliminate any effortless profits. In contrast, day trading profits are not effortless. Competition can reduce these profits, but cannot eliminate them.

The second reason is that news items ruin longer-term trading, whereas day traders are exploiting the news-related price movements. The news and mass media have a strong influence on short-term price fluctuations. The news is unpredictable because it is the product of the large and complex world outside the financial markets. It is unlikely that any one formula or principle can predict the behavior of the news because the number of variables involved is astronomical. Some people think that technical analysis (analysis of a price chart) will allow them to predict short-term behavior of prices (one week, one month, or one year into the future). These people are ignoring the huge unpredictable variable that is the news and the world outside the financial markets. Put another way, this explanation means that the immediate future (minutes to hours) is less uncertain than a distant future (weeks, months, and years).

Technical analysis is based on these two premises:

1. The past behavior of the price of a financial instrument influences the current price of this instrument. (The price chart influences future prices.)
   
2. The world outside financial markets cannot influence the price of the financial instrument. Alternatively, the world at large can influence the price, but this world is behaving in an orderly and predictable fashion.
   

Let’s say you have studied a price chart of a stock and figured out a recurring pattern that has worked well. Let’s say that you see this pattern forming right now and it is telling you that the price will go up in the next week or month. Can a piece of unfavorable news come unexpectedly and disrupt this beautiful pattern? According to technical analysis, it can’t, but according to common sense, it surely can. This does not have to be a news item, it can be a large sell order placed by an institutional investor. The price will go down and will wreak havoc on the chart pattern. Therefore, however consistent a pattern of price behavior may have been in the past, its fate is still uncertain in the future. Thus, position trading and speculation should have high failure rates, similar to the failure of 99.4% of long-term investors to outperform the S&P 500 index. The limitations of technical analysis that we discussed above may not be applicable to day traders. Successful day traders seem to go with the momentum of a price reaction to news items or to gigantic buy or sell orders.

The third reason is that day traders serve as the source of efficiency of the markets. If the market is efficient, then someone must be making it efficient, and day traders fit the bill. Thus, the consistent profits of a minority of day traders do not contradict the efficient market hypothesis. On the contrary, they may enforce efficiency of the markets. Day traders make sure that the prices of financial instruments quickly adjust to all publicly available information.