Sunday, May 21, 2006

The Market is Rigged Against Human Nature

Suppose you had two traders. One--a momentum trader--became optimistic and bought the S&P 500 Index (SPY) every time it rose in price for the day; the other--a contrarian--became optimistic and bought the S&P 500 Index (SPY) every time it declined in price for the day. Each trader held positions three days. What would be their return?

Since January, 1996 (N = 2584 trading days), the momentum trader would have an average return per trade of .01% (725 up, 617 down). The contrarian's average return would be .20% (679 up, 563 down). The trader who bought at the end of *every* day and held three days would have had a return of .10%.

In other words, simply by buying after a down day, the contrarian would have doubled the average return in the market.

By buying after an up day, the momentum trader severely underperformed the market.

Now you know why overconfidence in trading is the greatest pitfall of all. The market is rigged against human nature: getting excited after a rise and discouraged after a decline ensures that traders are on the wrong side of markets.