Short term share trading, gambling on rationality

Posted: August 5, 2012 in Economics, Game Theory, Life, Psychology

A friend recently approached me about share trading (technical trading combined with macro fundamental) as he knew that I have said some incredible insightful things in the past about market movements. He proceeded to ask me how much money I play with on the stock markets and too his surprise I said “Zero”.

He questioned me further as too why I read up and look into these things when I don’t invest, where I simply responded that finance and economics is an interest for me in the same way that other people are interested in sports, and while some people like to put some money down on their interests, gambling isn’t for everyone. Now he was even more confused and said to me that investing isn’t like sports, and went to say that sports is gambling because the outcome is random while the movements of share prices can be predicted.

I gave him credit and said that everything in life can be predicted if you had enough information and the computational power to process that information but for all extensive purposes both are gambling, where share trading is essentially gambling on rationality. Share trading is a game where the decisions of all collective players contribute to form the share price and any purchase of shares on the basis that the price will increase or decrease is reliant on a few key rationalisations;

  1. the share price is undervalued or overvalued, and that this is a rational conclusion
  2. all knowledge required to come to this rational conclusion is common knowledge
  3. all other players think exactly as you do and have come to the same rational conclusion
  4. you are able to come to and act upon such a conclusion faster than all other players

Ignoring the problems 4. creates and assume that you are able to act faster than others; the interesting issue is that 2. and 3. are not a given in reality where if you conclude that a share is undervalued while the majority of other players believe it is overvalued you will lose. Essentially it doesn’t matter what you conclude, you will only win if you can predict what the majority of players will conclude and act accordingly. Since 2. and 3. do not hold in reality, a winning formula relies on having superior knowledge and a firm understanding of how other people rationalise information. In essence, short-term investment is nothing more than a gamble on the rationality of others.

Final Remarks

The common form of this game is known as the Keynesian beauty contest and requires a successful player to be able to discard their preferences and act on the preference of other players. This of course doesn’t count for long term fundamental trading which is about long term performance of the company as opposed to gambling against the rationality of all other players.

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