Traders are idiots. Or, if you prefer to be more politically correct about it, traders are irrational.
Now, the efficient market hypothesis says that market prices include and reflect all relevant information at all times.
In other words, this theory suggests that stocks are trading at their fair value at all times.
If that is the case, then it’s almost impossible to beat the market.
As it turns out, however, that is NOT the case.
That’s because "all relevant information" refers to publicly available (past) data. And this tends to exclude a pretty crucial element of prices: the idiots.
Fortunately, there is a way to sort of quantify the idiot level that’s influencing prices. And it can help you beat the market with your near-term trades and other active investments.
I can prove it …
A Trading Disorder
An hour before penning this note to you, I opened a book called "The Hour Between Wolf and Dog." It was written by John Coates, who worked all over Wall Street in the ’90s. This fed into the idea of "trading the idiots."
But my first inspiration was a podcast that featured Richard Thaler, an economist and behavioral scientist, discussing a book he authored called "Misbehaving."
Thaler points out the fact that humans make irrational decisions all the time, especially in economic and financial situations.
In other words, we are idiots. But we’re in good company.
Where Thaler flirts with people "misbehaving" in predictable ways, Coates discusses an idea from a former British foreign secretary. That is, a disorder in traders he calls the hubris syndrome.
The common denominator is the perversion of success.
Hear me out …
How Do You Measure Success?
A principle just spelled out to me in the context of my faith goes like this: "Faithfulness is more important than success."
In other words: Our human vision of success or accomplishment is not necessarily the same as God’s vision of success. And remaining faithful to God is the only way of achieving God’s vision of success.
Furthermore, pursuing our own human success often produces the opposite.
From 1 Timothy 6:10, "For the love of money is a root of all kinds of evil. Some people, eager for money, have wandered from the faith and pierced themselves with many griefs."
In a different context, in markets, remaining faithful to the process is more important than becoming obsessed with the outcome. (Just ask the Chicago Cubs!)
Unfortunately, we too easily become obsessed with outcomes because they are pregnant with our selfish ambitions.
Thaler might use this to explain why we are irrational human beings.
Coates would reference the hubris disorder in agreeing we pervert power that’s associated with the chance of achieving overwhelming "success."
Let’s look at an example that seems to encapsulate these two outcome-oriented perspectives …
Got Groupthink? Run the Other Way
I probably don’t have to explain myself when I utter the phrase mob mentality. But, at risk of oversimplifying it, let me just say it is a concept used to depict the increased irrationality of human beings when they are influenced by groups.
In some instances, you might think the influence that peers have on a trader’s decision-making is a lot like "keeping up with the Joneses." Indeed, collectively, the Joneses are idiots.
And those "idiots" recently helped my subscribers make 119% on a crude oil trade in just 13 trading days.
Here’s how …
Now, it may not look like much on that chart. But where that red line plateaued was an extreme in large futures traders’ bullish positioning.
In other words, for whatever reason, everyone had jumped on the crude oil bandwagon.
Only it was a totally irrational move for those who came late to the party.
And those are the "idiots" I trade.
Those are the traders who, when they have piled in to an extreme, indicate an opportunity to make money by betting against them.
Now, idiots are not a super-precise indicator. So there are other indicators I use to help me optimize my timing when I recognize the mob has gotten bit unruly.
But in general, when all the "smart money" leans one way, the boat tips. Those who run to the other side can stand a pretty good chance of staying dry … and maybe even awash in profits, in 2017.