Finance is not like, say, surgery, where anyone who hasn’t been studying the field for years is unlikely to start criticizing professionals and say they can do it better—at least that’s not something I’d suggest saying to your doctor before going into surgery! Yet in finance, second-guessing, doubting, and simply dismissing people who have decades of experience isn’t just normal, it’s expected.
There are a lot of potential explanations for why cynicism is the default view on finance, but usually those cynical views are experts inelegantly—malapropisms, mispronunciations, and inaccurate analysis are the sorts of things pros immediately spot. And there are tons of quasi-canonical mistakes amateurs make that really singles them out from the pros.
1: Don’t fight the Fed(eral Reserve)
Perhaps the most common, and silliest, is how amateurs talk about the Federal Reserve. I’m not talking about weird arcane conspiracy theories or anything of the sort—I’m talking about getting the most basic things wrong, like the name of the central bank itself. Very often amateur investors and the general public will talk about the “FED” in all capitals, as if it’s an initialism like the FBI or CIA. It is not (the initialism would be FR, which no one ever uses), so if you see someone talking about “the FED” and not “the Fed”, they don’t know the name of the central bank itself, so why would you trust their opinions on central banking?
2: Yield, Return, Capital Gains, Oh My!
There are many terms used to talk about what you get from an investment. There’s yield, market return, total return, long-term capital gains, short-term capital gains, return of capital, net investment income, ROIC, ROI, ROA, ROE, IRR…and many, many more. All of these have very specific and different meanings, but that doesn’t get in the way of many retail investors, who confuse these terms and don’t see the subtle differences between them. Confusing return on investment capital and return on investment can misvalue companies by billions of dollars, but confusing yield and market return can result in falling for scams and losing all you’ve invested. Words matter, especially when talking about money.
3: You can’t beat/time the market!
There is a misunderstanding common among retail investors that the efficient market hypothesis states that market prices are perfect representations of all available information, and no one can legally find a better market price than the market itself; anyone who does so is merely lucky. The EMH is actually much more subtle, variegated, and complex; furthermore, professional investors are fully aware of the high efficiency of large-cap American stocks, but they are also familiar with the many other asset classes and indices in which the majority of fund managers do, in fact, outperform their index. Retail investors are unaware of this, and often unaware that there is more than one index.
4: Confusing returns and performance
Imagine a newsletter writer who wants to make a bundle convincing people he’s a market genius. He launches two newsletters under different names: one says go long Tesla (TSLA), the other says go short TSLA. Both are heavily data-driven, well written, and compelling. The newsletter writer can then gather a bunch of subscribers to both and, in six months when the stock has gone up or down, he can terminate the newsletter that gave the opposite advice. All of a sudden he looks like a genius. Retail investors are fooled by stuff like this all the time, but professional investors know that there are many, many ways to hide profits; they look for money-weighted, time-weight, and other returns, and look at actual account statements rather than professed claims of performance. Knowing what kind of performance is being touted, and how it compares to other metrics, is essential to pros—especially when you start looking at risk-adjusted metrics (Sharpe, Sortino ratios, et al.).
5: Not being humble
Last year was a very humbling year for just about everyone, but in 2021 the arrogance of retail investors swelled to the point that many started getting together on a confused moral quest to slay hedge funds, as if a sea of Davids had gathered together on Reddit’s Wallstreetbets. The hysteria has died down, with last year’s turn forcing a lot of humble pie down a lot of throats, and retail investor confidence is mercurial, going up and down with returns. Pros are deeply aware of this and the many other psychological errors that investors and traders naturally fall into, and they constantly look to avoid these mistakes by constantly being humble and aware that, someday, the uncaring invisible hand of the market can destroy their portfolios and their careers.
