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Whether you’re an amateur stock market enthusiast or a seasoned professional, everyone dreams of becoming a billionaire investor. However, there is always an unprecedented variable (factor X, if you will) that can ruin even the best-laid investment strategies. But somehow, each individual investor is convinced that he is the exception who is capable of beating the market. Can some of these claims hold true or does Efficient Market Hypothesis establish an ultimatum? In order to figure this out, we need to go beyond quantitative valuations and formulas and dig deeper into how real investors like you and me, perceive the market.

Participants in the stock market generally come under two categories: day traders and value investors. Day-trading is a style of investing in which you buy and sell a stock (or any other type of investment) within a short period of time (anything from minutes to a day or two). This type of investing is more of a career and is lucrative for those with higher capital and access to complex market information. Although we hear tales of overnight successes, there is a general consensus that day trading is not without considerable risks. According to the stock platform Etoro, it was found that a whopping 80% of day traders lose money over the course of a year with a median loss of -36.30%. Renowned investors like Buffett and Shark Tank’s Kevin O’Leary are firm opponents of this method and believe it to be akin to gambling.

However, the value investing method which they favor isn’t too promising either. Hendrik Bessembinder, a finance professor from Arizona State University analyzed the performance of 26,000 publicly traded stocks from 1926. The common return of stocks over the last ~100 years was a loss of 100%. Less than 48.4% of stocks out there delivered a monthly positive result. That’s just slightly higher than the roulette wheel. Moreover, out of the 1000 profit-making stocks, only 86 of them were responsible for half of the gains. This indicates that the effect of perpetual economic development in value investing is a myth. In fact, the market is being pulled up by a few super-performers, which compensates for losses suffered by the rest of the narrative.

The efficient Market Hypothesis (EMH) states that asset prices reveal all available information to investors and therefore, it is impossible to ‘beat the market’. Neither day trading nor value investing can help an investor generate returns greater than those of a portfolio of randomly selected stocks. This hypothesis is a widely debated one, wherein its opponents are quick to point out investors like Buffett who have ‘quite clearly’ won over the market. Here, it is imperative to understand that while the world sees the big gains made by these investors, we rarely consider the amount of losses they have incurred. As per Bloomberg Billionaires Index, the wealth of Warren Buffett has shrunk by about $19 billion (approximately 1/4th of his net worth) in 2020, due to his bearish take on the pandemic. This observation shows us that while EMH has its criticisms, it holds true in a general view of the market.

Now that we have established that no investor can consistently beat the market, we come back to factor X; the unpredictable variable that vastly influences profitability. The most identifiable components of factor X remain emotions and behavioral relations (as per game theory). Greed and Fear are the primary emotions that drive market fluctuations (bullish and bearish respectively). Greed for greater profits may cause even rational investors to keep waiting for a well-performing asset to reach the highest possible value before booking a profit. Similarly, a fear of losing money also causes investors to sell the stock as soon as it goes down in value, instead of waiting for the market correction. While taking greed and fear into account, it is also important to note that fear of loss is a much more powerful motivator than potential profit.

A much more comprehensive and modern aspect of factor X lies in Game Theory. Game theory is the science of optimal decision-making of independent and competing actors in a strategic setting. Here, a stock market represents a multiplayer, zero-sum game against sentiments. A famous example is the case of the newspaper beauty pageant, wherein participants are asked to pick the 6 most attractive faces from 100 photographs. The winners would be those who picked the most selected attractive faces. Therefore, three levels of thinking ensue, each more complex than the previous. The first level of decision-making would involve your personal choice of the prettiest faces. However, since the strategy would be to choose the faces others would think to be the most attractive, you accordingly begin your second level of decision making. This assumes that everyone else (except you) is making a first-level decision based purely on their preference. But you are in fact, making a third-level decision, i.e. which pictures will get the most votes, when all voters are basing their votes on who they think the most people will vote for.

This is how game theory integrates third level decision-making with the stock market. In the market, we mostly devote our intelligence to anticipating what the average opinion is expected to be. Game theory and emotions as components of factor X help to quantify the unpredictability witnessed in markets. Especially due to the pandemic and lockdowns, more people have time on their hands to try out trading strategies, which make markets all the more competitive. Therefore acknowledging and utilizing factor X while planning out an investment strategy will give you a deeper insight into how markets and the psychology of rational investors work.

By Nishitha BS


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