Shadow trade

“You have been given $100,000 to use for shadow trading on the stock market.

For the next 90 days, you are to maintain a trading diary. The diary must record the details of every trade, including a summary of the rationale for making the trade. If you sell one stock to purchase another then your diary must contain two entries, as these are two distinct investment decisions.

Largest portfolio at market close on the final day wins the competition.”

A murmur of excitement rippled through the class. We were a competitive bunch for the most part. This assignment provided an opportunity to show to our classmates whether we were really as smart as we thought we were.

Limping around the classroom, the teacher leaned heavily on a crutch as he handed out copies of the local newspaper. His teenage daughter had accidentally run him over during her first driving lesson. Leaving him with a life long reminder that learning by doing can make education a dangerous gig!

The teacher asked us to open at the finance section of the newspaper, then spent a few minutes teaching the class how to decipher the stock market price tables. Price. Volume. PE Ratio. Dividend Yield. Net Tangible Assets per share.

Flicking through the paper, I noticed that the news was at the front, while finance and sports were at the back. I asked the teacher why the share prices were reported so close to the sports scores?

He chuckled, “Sportspeople keep score using goals or runs. Share prices are how investors figure out who is winning in the game of business. Net worth is how adults keep score in the game of life”.

For the remainder of the lesson, most of the kids parsed through the stock market listings in search of inspiration. Just as many adults do, they chose their investments based upon a dubious combination of hope, intuition, and marketing.

The redheaded girl seated next to me had ignored her newspaper, choosing instead to catch up on some English homework. The teacher limped over to enquire whether she needed any help?

“Not at all. You said the winner will have the highest portfolio balance on the last day of the competition. These suckers are gambling. Betting on things they don’t understand and hoping to get lucky.

Some may.

Most won’t.

I’m betting that if I don’t invest, after 90 days my $100,000 balance will place me near the top of the competition.”

The teacher thought it over. Nodded. Told the redhead to write up her approach in her trading diary.

Shadow trading

For the next month, most students frantically shadow traded. Jumping in and out of positions like sugared-up toddlers bouncing on a trampoline. Reacting to whatever news, distraction, or whim happened to capture their attention.

Some followed the news.

Others attempted to anticipate what the herd would do. Then trade against them.

On day 30, the teacher limped into the classroom and asked each student to prepare a position statement that summarised their portfolio.

A leaderboard was created, ranking each student by their current portfolio balance.

Most of the students had a balance slightly below the original $100,000 they started with. Me included!

The redhead’s plan appeared to be working, ranking closer to the top than the bottom of the class.

The teacher asked what we had learned so far?

“Investing is hard. So many companies to keep track of. So much noise and gossip to filter through.”

“Newspapers report on what has already happened. It is old news by the time we read about it.”

“Those stock tips in the financial press are rubbish! Aside from a little spike on the day of publication, the recommended share’s price seems to mostly go backwards. It is almost as if someone is selling into the public interest the recommendation generates.”

“Those clowns who write narratives about why ‘the market’ did something must have smoked their breakfast. Thousands of companies. Millions of investors. All doing things for their own reasons.”

The teacher smiled and nodded along as the students shared their experiences and observations. Once the final contribution had been made, he told us he agreed with almost all of them.

Those challenges we had experienced shadow trading were shared by all investors.

As the class was packing up, he made an announcement.

“As happens with real-life investing, the rules of the game are changing.

Your shadow broker is now charging a brokerage fee of $10 per trade.”

Inside knowledge

That weekend I was working an uneventful shift at one of my after school jobs, in a one-hour photo lab. A comforting cadence of develop, print, inspect, and sell.

We would occasionally see famous people in the prints we produced.

Actors. Musicians. Politicians. Sportspeople.

Doing the everyday things that everyday people do. Barbecues. Birthday parties. Family get-togethers. Holiday happy snaps. Weddings.

Sometimes candid images were taken by stalkers, voyeurs, or wannabe members of the paparazzo. Spying a celebrity walking through an airport. Dining at a restaurant. Drinking at a bar.

That day, a curious photo caught my attention.

The familiar face of a megacorp CEO. He appeared to be arguing with another vaguely familiar man, wearing an ill-fitting suit and a world-weary air. Angry expressions. Pointing finger. Red faces. Tense body language.

In the background, the airport newsstand displayed the previous day’s newspaper front page.

I asked the shop manager whether she recognised the second man in the photo?

She thought he ran one of the civil service departments. Based on his photos we had processed, he was married with a kid and enjoyed fishing. Judging by some photos another woman had brought in, he appeared to be cheating on his wife!

I grinned. My manager was a shameless gossip with a freakishly good memory for faces.

That got me thinking.

I had read in the financial press that a regulatory inquiry into corporate shenanigans by the megacorp was due to report its findings the following week. If the CEO was blowing up at a department head, did that mean the findings were unfavourable?

It was possible.

It was also possible that the department head had simply queue-jumped at the airline check-in counter.

I recalled a memorable line from the movie Wall Street: “You stop sending me information, and you start getting me some”. If my deductions proved to be correct, then this was an example of the latter. I suspected something would occur that wouldn’t be reported in the papers until next week. There was opportunity in that information.

Deciding it was worth taking a punt on, I did the thinking about which companies stood to benefit from an adverse report. Then I shadow traded to capitalise on that potential outcome.

On day 60, the wild-eyed teacher limped into the classroom. His teenage daughter had just failed her driving test. She had gotten flustered. Put the car into drive rather than reverse. Looked back over her shoulder, gunned the accelerator, and crashed into the wall of the motor registry! A little bit of knowledge can be a dangerous thing.

He asked the class to prepare their portfolio statements, this time factoring in brokerage charges.

Once again, the leaderboard was produced.

My ranking had improved to second place. Shadow trading on the inside information had paid off handsomely.

The redhead was a close third. The friction introduced by brokerage charges white-anted the returns of the rest of the class. Most of them now had portfolio balances well below the original $100,000.

The teacher asked what I had done differently this month to improve my standings?

I told the class about the photo, the inquiry report, and my hunch about the outcome.

The teacher applauded my lateral thinking, then explained how insider trading rules were designed to prevent investors from profiting on information that was not available to the general public.

The competition leader explained his unlikely success. He had gone all-in on a small local company, shortly before rumours that an overseas giant was planning to acquire it as a means of entering the domestic market. The share price skyrocketed.

The teacher asked what we had learned during the second month of the competition?

“Investing is mostly down to luck. The kids in the top two places both got lucky.”

“Technical analysis is bullshit. Divining patterns on price charts to predict what will happen next is crazy. Patterns are only certain in hindsight, and by then the market has already moved on.”

“Annual reports suck! The glossy part at the front is just marketing to make the current management’s performance sound good. The boring numbers part at the back is supposed to say what really happened to the company last year. But even that contains lies! Intangibles, provisions, and goodwill are all just some bullshit random numbers that an accountant made up on the spot.”

The teacher nodded, unable to disagree with any of the points. He didn’t have the heart to tell the class that fundamental analysis was often just as flawed. The same folks who use backwards focused financial metrics to try and predict future outcomes issued their work product under a standard warning that “past performance is no guarantee of future results”.

“Ok, the rules of the game are changing again.

The government has imposed a shadow capital gains tax. Every time you sell at a gain, you owe the government 47% of the profits.

This change is retrospective, going back to the start of the competition.”

A chorus of protest and grumbling erupted from the class. Retrospective rule changes? That was so unfair! How could the government pull the rug out from under the feet of the investor like that?

Games of chance

The final 30 days of the competition saw some fascinating behavioural changes amongst the class.

By that point, most of the kids had given up.

Researching and staying current with the financial news consumed all their available time, yet appeared to have little correlation with their investment outcomes. Gossip and rumour move the market far more often than facts or fundamentals.

Bloviating talking heads espoused opinion as fact and confidently made predictions in the press. Evaluating their past track record was fundamental to determine if they were worth listening to, yet this exercise was something few bothered with.

The ever-changing environment of fees and taxes further discouraged participants. Particularly those who had committed to strategies that were now being adversely impacted by the changing rules.

The overall market had declined throughout the competition period, leaving many players with smaller portfolio balances than they had started with. This was disheartening, particularly as the competition timescales left little time to recover.

On the final day of the competition, the teacher limped into the classroom appearing ill. Glassy eyed. Grey skin. Sweating. The poor guy looked like he was going to lose his lunch. His teenage daughter had just passed her driving test, on the fourth attempt. Having seen her drive, he was terrified! The examiner had mistaken one-off good fortune for competence.

He instructed the class to liquidate their shadow portfolios at the previous day’s closing market prices. Deduct brokerage fees and outstanding capital gains taxes. Then produce their final position statements.

Third place went to the redhead. Her capital preservation approach proving savvy in a down market.

Second place went to a boy who embraced the inside knowledge approach.

His elder sister worked at the airport executive lounge, which on Thursday and Friday nights was full of politicians and lobbyists heading home for the weekend.

He took to asking her about who the cabinet members held off the record meetings with, then shadow traded based on his best guess about the meeting outcomes. When this failed to work fast enough for his liking, he tried phoning in tips to the local newspaper, attempting to move the market with planted stories.

The winner of the competition was… me!

I wish I could claim that my performance was due to genius or talent.

Alas, that would be a lie.

No, in the final month of the competition I discovered the “penny dreadfuls”. Small issues of out of favour stocks. Languishing at the bottom of the market, trading at share prices of just one or two cents.

Sound investing this was not! There was often some very good reasons why the market didn’t rate these companies.

One of the “penny dreadfuls” was a struggling mineral exploration company. In the competition’s final week, the company announced a major new mineral deposit discovery. The share price surged!

At competition’s end, my shadow portfolio balance was worth more than $1,000,000!

Amidst cheers and accusations of cheating from my classmates, I performed the victory dance. The teacher let the air out of my tyres by reminding me to deduct the 47% taxes owed. Ouch!

Lessons learned

I learned a lot of lessons from that high school shadow trading competition that have helped me become a better investor.

The value of early information.

The difficulty in obtaining it.

The folly of trading without it.

The cancerous impact of fees and taxes.

The bizarre methods that some folks employ to convince themselves that there is empirical science underpinning a market populated by an unruly mob who exhibit herd-like behaviours as they irrationally lurch from fear to greed and back again.

In the years since the competition, I have worked with both investment banks and regulators. These experiences reinforced rather than dispelled those lessons.

Trading is an insiders game. A business only for those with the means to move the market.

The rest are mere speculators. Placing bets and hoping for the best. And as we all know, hope is not a sound financial plan!

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References

• Wall Street (1987), Twentieth Century Fox

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