The Basics

Noise Trading

One of the more interesting topics I’ve come across in my delving into research in the area of Behavioral Finance is the term “noise trader”. I’ve been reading a paper on the subject which has former Treasury Secretary Larry Summers as one of the co-authors. To put it simply, noise traders are those who do not operate on a strictly rationale valuation basis when making buy/sell decisions in the market. In other words, if you’re reading this blog post you are almost certainly a noise trader in the way academia defines the term.

One of the things I find interesting is how Summer & Co. refer to the non-noise set of market participants as “sophisticated investors”. The implication is that these folks can build a proper valuation model with the correct inputs that correctly account for risk. The implication is that noise traders can’t correctly estimate future risk (among other things), while the so-called sophisticated investors never makes any errors in estimating all the contributing factors which go into a valuation calcuation. Not very realistic in a world of failable human actors, in the latter case, or in terms of valuing the abilities of some very smart researchers on the other.

What’s kind of funny is the expressed observation of the paper that noise traders make value investing a sub-optimal course. One the one side, noise traders are said to increase volatility, and thus risk, reducing asset prices (stocks, really) in terms of their attractiveness to the non-noise set. On the other side, the added volatility actually increases the returns accruing to a noise trading approach. I think a lot of traders will feel vindicated in this. 🙂

I haven’t gotten all the way through the paper, and there’s a lot of very academic stuff, so it’s not the easiest read in the world. For those with an inclination, though, it’s an interesting bit of intellectual discourse.

Trading Tips

Investing vs. Trading in Forex

With the advent of the Currensee Trade Leaders program, the idea of investing in the currency market has been brought to the fore in a way it never was previously. We can now really think of “investing” in forex, not just trading.

Trading vs. Investing
Actually, the term “investing” has been used in terms of forex before. It’s been used in the same way one talks about investing in individual stocks – as a loose term that also accounts for what we would call trading. I’ve written on the subject of differentiating the two approaches (Trading vs. Investing, The Difference Between Trading and Investing), so I won’t get into a lengthy discussion here. I’ll just suggest that investors tend to be much more prone to using fundamentals and much less inclined to use leverage. This article on a personal finance site uses the term “investing” but clearly is talking about what I (and I’m guessing you) would call “trading”.

Forex trading, alas, continues have a very negative connotation among investors. A couple of comments on the aforementioned article talk about how quickly you can lose money. One commentator says “This is akin to day trading on margin & is the easiest way to ruin your financial life”. Of course this assumes all forex traders are day traders and one need only look to the Currensee community to realize that’s not the case at all. But I don’t think any of the Currensee members would call themselves a currency investor.

Forex Investing
But that’s not to say forex investing hasn’t been available. We’ve had currency ETFs and the like for some time now. They allow for both trading and investing in the forex market. Traders can obviously use them to play shorter-term term moves, though my guess is most lean toward the spot or futures market where more leverage is available. After all, day-to-day volatility in exchange rates is on the low end of the relative volatility scale among the markets.

The currency ETFs, though, allow investors to play the bigger macro themes in the market. Think the euro is going to blow apart? You can play the euro ETF. Think the Fed’s printing of money via quantitative easing is going to massively devalue the greenback? There are dollar ETFs you can play to take that position. Just in the last year we’ve seen a couple of 10%-20% swings in the USD Index that investors could certainly have played based on macro themes.

Investing in Someone Trading Forex
The Trade Leaders program adds another dimension to the possibilities of forex investing. I’ve already commented on some of its benefits (see The Benefits of Investing in Successful Traders). Above all that, though, is the opportunity the program provides you as an investor can put someone (or several someones) with a demonstrated track record to work managing your money, like mutual fund investing or other money management programs. Are there functional differences? Sure. The main concept is the same, though, in that you can have your money working in a way you likely wouldn’t be able to do yourself.

Trading Tips

Individual Stocks are Bad

There’s a post on the Moolanomy site about the subject of investing in individual stocks. Which makes a couple of statements worth addressing.

The first is:

…no one should own individual stocks

You might think I’d argue against this particular statement, but I won’t. Speaking strictly from an investment point of view (as opposed to trading), holding individual stocks is probably not something most people want to do. It takes a sizeable portfolio to be able to create a well diversified portfolio (like 30), which is difficult for many individuals to reach. That means ETFs and mutual funds tend to be the better choice.

Here’s the other bit I wanted to comment on:

One of their studies found that the stocks individuals buy underperform after they buy them and outperform after they sell them. This is actually a commonsense outcome. The reason is relatively simple. Let me explain. For every buyer there must be a seller. Since the vast majority (about 80%) of the trading is done by institutional investors (who almost certainly know more than the individual investor) that it is likely that when an individual buys a stocks (because he thinks it will outperform the market) the likely seller is an institution (who thinks it will underperform or they would continue to hold it). And the institutional investor is more likely to be right.

The institutional investor is more likely to be right? Hmmm…. I’m not entirely sure of that, but there are a couple of links in the post to research which are said to support these statements. You may want to check them out. I haven’t had the time to do so as yet, but do wonder whether the academics of it are overly narrow as is often the case in situations like this.

Again, this is investing talk, not trading talk. There’s no suggestion here (especially from me) that trading individual stocks is a bad idea.

Reader Questions Answered

An Investor Learning About Trading

Here’s a note I received from an investor looking to maybe dabble in the trading world.

Hi John, Actually there r no puzzles. I have been investor all these years. Have researched many companies. Have set up my own investments co. But i have always been more fascinated by trading. I have been reading Market Wizards books since last few days. I have found them very interesting.

In past due to loan defaults, i lost big money which i had loaned to my relatives and friends. It took me ten years to make back which i lost due to no fault of mine. I was just patsy and did not have any guidance.

However, if you recommend anything, i m all ears. I am serious about learning how to trade profitably. Have met Jim Rogers in past when he visited Mumbai.

In my book I made the observation that functionally (if not philosophically) trading and investing are essentially the same thing. By that I mean when investing you have a process and a methodology for identifying prospective investments and making investment decisions and in trading you have a process (often called a system) for identifying trade opportunities and making trading decisions. Those processes often have numerous similarities, though the time frames involved are generally not one of them.

I think the major issue for someone trying to get into trading after having been an investor is deciding which market to do that in. The obvious choice would be to stay in the stock market, since the investor is already knowledgeable there (presumably). I’d suggest that maybe a different market might be the better idea, though.


Because one of the risks of having a split trading/investing focus is that trades become investments and investments become trades. By that I mean a position that was intended as a trade turns into an investment when the trader starts altering the way he/she looks at the position, and vice versa. Invariably, this becomes a disaster waiting to happen because risk management rules get tossed aside – usually at the worst possible time.