Last Friday, I stopped by the bookstore on my way home from work and bought a book titled, “Open Heart Surgery for Dummies.”
It was a great book. I read it cover to cover over the weekend. I learned about the atria, the ventricles, the septum, and the blood vessels. And I must say, I feel like I am quite the expert on that little muscle on the left side of our chest that pumps blood throughout the body now.
In fact, I wanted to put my newly acquired skills to the test in the operating room. So I called up a hospital Sunday evening, and miraculously, to my surprise, they agreed to let me perform a surgery. Apparently there is more demand for the surgery than there are people capable of performing the open heart procedure, so they were happy for extra help.
And I am just going to stop there.
No sane person would walk into the medical section of a bookstore, find a book on open heart surgery, read it over the weekend, and then believe they can walk into an operating room on Monday morning and perform a successful open heart surgery.
Now consider story number two. Someone walks into a bookstore, finds a book titled “How I made a million dollars last year in the stock market”, reads it over the weekend, and then starts trading Monday morning expecting to beat the professionals. This may not be a life of death situation like the first scenario, but they both share a similar story of a beginner thinking that they can be as good as the experts in a very short period of time. Yet, the first story sounds absolutely ludicrous, while the second sounds reasonable.
Because you do not need to be an expert to be successful in the stock market. If you have 10,000 people flipping coins, statistically, around 10 people would flip either heads or tails 10 times in a row. These people aren’t skilled at flipping coins. They are lucky. The same idea applies to picking stocks. There are always going to be people who guess correctly many times in a row. These people are the small minority. The other people are the large majority who were not as lucky. These are the people that failed. And you never hear about the failures. The graveyard is silent, as Nassim Taleb would say.
In a casino, the house wins. But despite the casino’s odds being better, you are always going to people who have “beginner’s luck” due to the sheer number of people gambling. For example, the probability of red showing up 5 times in a row on a roulette table is low – around 3%. But if you have 100 people betting $100 initially on red to show up five times in a row, statistically 3 people would win. 97 people would have $0. But 3 would have $3200 (doubling $100 5 times in a row). And these are the three people you hear about – not the other 97 people who failed.
We are often overconfident, exaggerating the part that skill played and underestimating the role that luck played in the outcome. Danny Kahneman wrote 66 pages on the topic of overconfidence in his book, “Thinking Fast and Slow.” Here’s an example from the book…
The chance of survival for a small businesses after 5 years in the United States is about 35%. But the individuals who open such businesses do not believe that these statistics apply to them. 81% said that their odds of survival after 5 years were at least 70% and 33% of the people said their chance of failing was 0%.
Here’s another example of overconfidence – try answering this question: Are you an above average, average or below average leader? When asked this question, 70% of high school students said they were an above average leader, and only 2% said they were below average. Countless studies support this idea that people, on average, believe themselves to be above average.
Aside from trading in the stock market, the potential for even temporary success does not exist in any other skilled profession (that I can think of). I might be confident in my ability, but it is not realistic to think I could beat Lionel Messi at a game of soccer after practicing for one week, one month, or one year (or ever). Regardless of how long the game is, Messi is going to win. But with the stock market, a beginner could beat a titan like Warren Buffett in the short term. I can get lucky one year, or maybe even for two or three, but expecting this luck to continue and beat Buffett over a ten or twenty year period is extremely wishful thinking.
I got lucky when I first started “investing” (looking back it was more like betting than investing at this point). I remember buying a Groupon called the Five-Step Trading Stocks Online Course, from the Lex van Dam Trading Academy. I completed the course and soon after put my newly acquired “skills” to the test and bought a few stocks in individual companies. It was exciting! And that was the problem. When participating in the markets becomes exciting, you are gambling, not investing. Investing is not about entertainment. It is about making money.
I was guilty of being overconfident in my abilities, and eventually sold my individual stocks to buy ETFs. Luckily, I actually made some money. But even “a fool must now and then be right by chance.”