The Art of Predicting a Coin Toss

The Art of Predicting a Coin Toss

"October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February." – Mark Twain

Gambling is exciting, entertaining and extremely addictive. From the time that you place a bet till the final outcome is decided, there is a rush of adrenaline that is quite similar to the high people get from using addictive drugs! In fact, after 15 years of extensive research and study, the American Psychiatric Association decided to change the classification of pathological gambling from an impulse control disorder to an addictive disorder. It is no wonder that the size of the gambling industry in India, both legal and illegal, adds up to lacs of crores each year. The small segment of Indian casinos alone accounts for 500 crores in annual earnings.

There is usually no harm in gambling with a little bit of spare cash that you wouldn’t mind losing - as long as you realize that there is a high probability that you will never see that money again and are comfortable with that knowledge. What is really dangerous is when you engage in an activity without realizing the stakes and risks involved; when you start gambling with money that you need to pay next month’s rent or your children’s education after a few years! Does that sound like something you would never do? You’d be surprised how many people end up doing just that and realize their mistake only once it too late to recover.

Most forms of gambling are illegal in India. Other than a few legally established casinos, horse racing, and some lotteries, all other forms of gambling, sports betting and even online gambling are prohibited by law. Although, there is one form of gambling that is not only legal, but strongly encouraged and perpetuated by the largest financial institutions of the country – even though these activities are in direct conflict with the moral and fiduciary responsibilities towards their customers.

What makes it all the more dangerous is the fact that people don’t realize that they are gambling with their hard-earned money.

A Random Walk

According to Wikipedia, the random walk hypothesis is a financial theory stating that stock market prices evolve according to a random walk and thus cannot be predicted in the short term. Empirical data provides strong evidence that, at any point in time, there are hundreds of factors, some known and many unknown, governing the short-term direction of stock price movements. There are innumerable examples when markets have responded exactly opposite to expectation after a major event. Of course, hindsight is always 20/20 for market analysts and financial experts. After each and every one of these surprises, these experts always seem to have valid explanations as to why markets responded the way they did and not the way they had predicted before the event!

The recent US Presidential election is a glaring example of this behaviour. Before the election results were announced, most financial “expert” predicted dire straits that lay ahead if Trump was elected. There was talk about stock market Armageddon, 10% price crashes or even worse. The day after Trump was elected, the market closed higher than the previous day, up 1.1 – 1.5%! And in the following weeks, markets were on a consistent uptrend, gaining more than 5% rather than tanking 10% as predicted.

And, when it became evident that the markets are headed upwards, the “financial experts” were ready with solid explanations why the rally would continue. All of a sudden, Trump’s policies had turned positive for the economy and stock markets.

Tossing the Coin

American economist and Nobel laureate in Economics, Eugene Fama concluded in a research paper titled “Luck versus Skill in the Cross-Section of Mutual Fund Returns” that, after accounting for management fees, the performance of active managers is no different from what would be achieved by picking stocks through a coin toss. In other words, there is no evidence of fund managers with skill sufficient to cover their additional costs.

Predicting short-term trends in stock markets based on news and various real-world events is equivalent to predicting the outcome of a coin toss. Even a monkey trained to call “heads or tails” will be correct half the time in predicting the outcome of the toss. The impact of a particular political or economic event on the next day’s or week’s price movement is no different. The problem starts when people making those predictions start thinking that they can accurately forecast these price movements. It is worse for people who listen to these experts and gamble their hard-earned money based on random guesses.

Does that sound like something you would never do? What is described above is the basis for 90% of all retail investment activity in the Indian stock market.

Investing vs. Trading

There is only one way to avoid the biggest mistake when dealing in the stock market - realize that the only money to be made through stock investing will take years of patience and consistency.

Investing should be more like watching paint dry or watching grass grow. If you want excitement, take your money and go to Las Vegas. - Paul Samuelson, American economist, and the first American to win the Nobel Memorial Prize in Economic Sciences

The moment you think about making a quick buck based on some random stock tip or when you decide to buy a stock option to earn 3x returns in a couple of weeks is when you have already lost. That one stock tip might even give you 50% returns in the next few months. The stock option might even triple your money in a few days. But when you start doing the same thing over and over again, you will make money in one trade and lose in the other nine. Some “smart” and “experienced” traders may even manage to make money in seven trades and lose in three. But then one fine morning, the market will open 10% up or down and wipe away the last few years of profits.

Did you know that less than 6% people who try their luck at professional trading actually succeed? And less than 2% of day traders end up being profitable in the long run?

Biased media coverage and false claims made by scammers have created this idea that stock trading is a glamorous profession where you can get filthy rich in a few years. What no one seems to talk about are the 98% traders who end up losing more money than they can afford or taking on debt that they will spend an entire lifetime paying off.

Although investing can literally be as boring as watching paint dry, but that is the only way to create long term wealth through stock investing! Don’t try to predict the outcome of a coin toss… and even if you do, don’t bet your next month’s pay check on it.