The market traps

Knowing where the trap is—that's the first step in evading it.
Frank Herbert, American science fiction writer in his bestseller novel “Dune”

The only sure way to success in investing is having a long-term perspective. There are many people who are trying to sell you that you will become very rich very quickly. Maybe this accounts for some people who work day and night and have the respective luck – however, this is not an investment strategy that you can pull off with limited access to data and besides your daily job. Learn in this article how to be aware of frauds!

The market traps

1. Ratings are influenced by the people who make the ratings

[...] there's a really nuanced point in this, because if you have ten rating agencies out there, and I can choose among them, I'm gonna choose for one of two reasons, maybe both, price and laxity.
Warren Buffett, American investor, CEO of Berkshire Hathaway, considered one of the most successful investors in the world in a CNBC interview

Many companies deliver Information and news, e.g. Thomson Reuters. However, the cost is usually too high for an individual investor. Therefore, many individual investors rely on other investors and rating agencies. However, the last financial crisis in 2008 showed that many rating agencies did not do their job well. One specific reason for this is that the people who employed the rating agencies themselves were selling the financial instruments that were rated. This means there was no interest in an independent and reliable rating.

Ratings can even be a bad sign as funds only receive a good rating after a good performance of the last 5 years. The probably is that the managers already made the right choice, took a big share of the possible gains and that the future performance might not be so good as the past performance was already very good.

[..] over the course of a 10 year period beginning March 1995. [..] it becomes clear that the predictive performances of the different rating systems used by Morningstar do not beat a random walk.
Roman Kräussl and Ralph Sandelowsky, Researchers at University of Luxemburg and University of Amsterdam

A study based on Morningstar ratings released by Roman Kräussl and Ralph Sandelowsky shows that ratings only describe the past performance and have no impact on the future.

2. Day-trading ends for most traders in losses

If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes.
Warren Buffett, American investor, CEO of Berkshire Hathaway, considered one of the most successful investors in the world

Day trading is the short-term trading with securities, usually within a day. Already in the early beginnings of day trading, it was found that day trading is not a suitable strategy. The North American Securities Administrators Association study found already in the year 2000 that 77% of the 124 investigated day traders made losses during the 8 months timeframe. The average profit of the remaining traders was $22,000 meanwhile only 2 traders made profits of more than $100,000.

There are several reasons why day trading is not a serious investment strategy:

  • Stocks fall quicker than they rise. This means on average you lose quicker than you win.
  • Unique events usually cause major downward trends but not major upwards trends, e.g. 9/11 or the Leman Brother’s bankruptcy. There is no unique event that put stocks on a straight rise
  • With every trade there are commissions to pay. Even outperforming the market in a manner that gives the day trader the costs for the trades back is for most of them not possible.

Whenever you meet someone who is bragging about his day trading skills, he probably just showed you a certain part of his trading where he was lucky and he does not show you all the times where he lost money.

3. Professionals in the market try to influence you to buy stocks for their own advantage

Our view is you have to assume there’s a trader sitting in some house in London or Singapore or Podunk, Iowa, trying to do bad things in the market.
Robert Greifeld, CEO Nasdaq OMX Group Inc.

There is much free investment advice out there, especially from banks. But why should a bank give you free information? Why does the bank pay expensive analysts to give you tips? Banks that publish findings or investment advice usually buy stocks the day before they publish the news. The day they publish the news the many followers of the bank will buy the suggested stocks and the banks can make a profit within a day. This is not illegal as this is not insider information. The bank uses its advantage that they know their opinion and the time of the release of the investment advice. The bank also knows its impact and can estimate the movements on the market.

Other scams on the internet work with similar strategies, where you receive investment advice on stocks that the scammers have invested in before. According to a study by Laura Frieder scammers can make about 4,29% profit with one mail.

4. Summary

Infographic with a summery of the article: The Market Traps

As a private investor you are in a weak position to beat any professional in the short-term. You have less information and the information you get is not independent but controlled by people who have their own interests. Therefore, look at long-term strategies and only buy into reliable products with low costs. Before learning how to invest, you should know the major mistakes that you can make. Take the quiz below and continue reading our next article!

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