Mike Taylor: The hard truth about predictions and paper trades

Mike Taylor

Mike Taylor, co-founder and managing director of boutique investment manager Pie Funds talks about predicting markets and trading on paper alone.

"I don't know - honest"

"I don't know where the market is going." I first heard this from a trader friend of mine when I quizzed him on the direction of crude oil futures. The conversation:

Me: "So, Mark, is oil in a bubble, do you think the market has topped?"

Mark: "I don't know."

Me: "But what do you think? Is it going higher or lower?"

Mark: "I honestly don't know where the market is going. I don't have an opinion. The market can go as high as it wants or collapse tomorrow. I trade what I see."

Mark was trying to tell me he didn't make predictions - he let the market decide where its next move was.

At the time, I thought he was a nutter. How could anyone possibly trade when they had no idea where the market was headed? This style completely contrasts with financial commentators and financial entertainment TV, where there is always opinion. How often do you hear some commentator say, "I'm bullish on commodities", or "Real estate is going down", or "We're buying healthcare companies because we predict that's the next sector to go up."

Later I realised Mark was on to something.

If I have no opinion of where the market is headed then I have no bias, and if I have no bias I can trade or invest with a clear head and make decisions without clouded judgement.

In fact, Mark never watches financial TV, rarely reads the financial press and does not blog. He gets all the information he needs from the price and, to a lesser extent, from the company or economic facts.

This won't work for everyone; however, know that all forms of financial media - blogs, TV or press - exist solely for entertainment purposes and should be treated accordingly.

Do you think you know where the stock market, the real estate market or oil prices are going? If you have an answer, erase it. Trade and invest on the facts you have today, not on what the future may bring, because sure as eggs, it won't happen as you predict - and if it does, you were just lucky this time.

If I knew where the stock market would be in six months, I'd be writing this from my yacht off Monaco.

Paper trading is for puppets

People frequently endorse paper trading, which involves running a dummy portfolio where you buy and sell assumed positions. The idea is that it gives you a chance to test the water without committing any money. Big mistake. I've never known anyone to lose money paper trading - everyone turns a profit.

Paper trading doesn't work for several reasons: there is often a lack of commitment, unrealistic price and timing assumptions, and most importantly, it has no emotional quotient. You don't care if you win or lose because it's just paper; therefore, you normally end up following your trading strategy perfectly. Without the emotional commitment you trade without fear, which puts you 'in the zone'.

What generally happens is that after people have had success paper trading, they think it will be a cinch to enter the real market and play with actual money instead of a spreadsheet. Bingo!

If you don't believe me, try it yourself and see the dramatic change in the way in which you trade/invest. As soon as you're risking your own coin, you're emotionally involved and your strategy goes out the window.

For instance, you might vow to cut your losses at 10 per cent regardless, and with the paper portfolio you adhered to this. Say your first real trade starts going down from purchase, and you are on a 10 per cent loss by the end of day one.

What is your reaction? Denial. This can't be happening, you made money on paper. You review your purchase decision, it all stacks up and there is no reason for the price to fall. In fact, you want to buy more now, not sell out. So you hold. The loss grows until finally it hits your pain threshold. Then you bail. First hit, massive psychological blow. Market 1. Trader 0.

An alternative scenario in which the trader starts with five winning trades in a row. Strategy out the window. The most common mistake at this point is to get greedy. You think, I'm not making enough money, I'm only risking 2 per cent of my portfolio. I know what I'm doing, I'm going to beef this up - put my balls on the line. Let's tip the whole lot into one trade.

But the trade turns into a 10 per cent loss. You decide to double down - the market has to turn. Another 10 per cent down and then what! The stock has just gone into halt. Profit warning. Game over. Market 1. Trader 5. But the market won the only trade that counted.

You retreat and lick your wounds, read as many books as you can, determine to return the champion armed with all the knowledge you can gather. But you make the same elementary mistakes over and over.

All you needed to do was trade without fear and adhere to your strategy, whatever that is. Because generally, if you limit your losses, unless you are a complete fool you will win more than 50 per cent of the time, in any market. In the beginning, you must stick to your strategy until it becomes so ingrained that it is second nature.

If you want to trade paper, go back to your paper round.

Forecasting or crystal-ball gazing

My wife and I don't care if we miss the entire nightly news bulletin, but we like to be in front of the box for the final part. Why? The weather forecast. We don't want to look out the window or check the barometer, we want someone to tell us 'the future'.

I think forecasting is built into the psyche from a young age. Humans love predictions - we like to 'know' what will happen, because it gives us a sense of control.

We like to forecast everything we do in life. What's the weather tomorrow, how long will this take, what day is your baby due? The problem is that people interpret these forecasts as accurate expectations, while in truth, most are little more than a best guess. If they are right, it's often due to random luck. That's when the cracks start to appear.

At the time of writing, last night's forecast was for thunderstorms, yet the sky is clear. No rain, wind, thunder. How could a forecast possibly be wrong only 12 hours out? But such errors are common. Why? The simple answer is that weather is unpredictable - patterns can change in unexpected way. Just like the stock market.

A group of people who should never give forecasts are economists. They must be wrong more than they are right - certainly not more than 50/50, which suggests that their forecasts are purely random at best.

The best thing that forecasts can do is measure probability. If it's summer, we all know that there is a high probability of having a nice sunny day, and if it's winter there's a good chance of cold and rain.

Next time you hear someone forecast the stock market to appreciate or depreciate 10 per cent this year, take it with a pinch of salt, because it's nothing short of a guess.