Editor’s note: People are irrational creatures. And perhaps never more so than when it comes to the stock market. Today, eccentric former hedge fund manager James Altucher shows you the key to capitalizing on that irrationality.
Our brains are messed up. Daniel Kahneman, the Nobel Prize winning economist, calls the ways we are messed up “cognitive biases.”
Our cognitive biases make us sell stocks whenever everyone else is selling. Cause us to buy stocks when everyone else is buying. This is called “herd behavior.”
Another cognitive bias is called “loss aversion.” We’d rather make a bad decision than lose money. So we sell too quickly.
Cognitive biases almost always force us to make bad decisions. This is why markets and stocks sometimes go up too high. Much higher than they should.
And this is why markets go down much lower than they should.
But this creates MASSIVE opportunity if you have an unfair advantage.
Kahneman says, “It’s impossible to act rationally. It’s impossible to get rid of the cognitive biases.” Impossible!
People are irrational all the time. If Microsoft goes down five days in a row, people sometimes think, “That’s it! Microsoft is dead! Time to sell.” And then it keeps going even lower because of the new crazy selling.
What was the news? Maybe Microsoft missed earnings by a penny. Something trivial. But people go crazy.
I go crazy.
So I did what I always do. I wrote software. I took the emotion out of my trading.
Capitalizing on Others’ Irrationality
I knew all the cognitive biases. I had studied them. The stock market is like the collective psychology of the entire planet.
If individuals can make irrational decisions because of these biases, then so can the entire market. So can you. So can I.
My software helped me find 100s of patterns where I was able to prove people were acting irrationally.
If you invest in the opposite direction of millions of crazy people, you make a ton of money.
I didn’t know anyone else doing this at the time. There were a few secretive hedge funds. Some of the patterns I found were unbelievable. I couldn’t believe there were opportunities to make 100%, 200% or even more in a day.
Other patterns were insane. Like if a biotech company has a drug that caused brain cancer… wait two days and then buy.
Other patterns were so consistent I called them “ATM machines.” One time I wrote about one of these ATM machines on a very popular website.
I started day trading more and more money. Top hedge fund managers were even giving me their personal money to trade.
Some days I would trade over $1 BILLION worth of equities. In a DAY.
Patterns Are the Key
All because of my software. I took the emotions out of it. I only traded when the software saw a pattern kicking in.
I’d go out to lunch sometimes and come back and see that the software had found a pattern, made the trade, and already exited with a profit.
I had no job. I had two little babies to feed. I had expenses and little money. I had to make 100% per month just to make my expenses.
And I built a business trading for other people. In my first few months doing this I made over 150% for my investors and more and more people invested with me. Almost every day was a profitable day.
I didn’t know anyone else doing this at the time. There were a few secretive hedge funds doing it.
And then I did it. Then I built a hedge fund and invested in many traders.
I wrote a book about some of the patterns my software discovered. The Stock Trader’s Almanac named it their “Top Investment Book of 2004.” Barron’s listed it as one of the top 10 investment books of the year.
One of the hedge fund managers who had given me money pulled all his money away from me then. “You can share with some people, but not EVERY person.”
“People Are ALWAYS Irrational”
Here’s the thing. Here’s the universal secret about investing:
- People are ALWAYS irrational. Which means there are always patterns in the market that will make a lot of money. Yesterday. Today. Tomorrow. New patterns.
- Having software to find new patterns is an UNFAIR ADVANTAGE.
DO NOT INVEST unless you have an unfair advantage.
In 2008 I found new patterns to invest. Patterns that worked every day. While the world was burning, I was making money. I made money on the day Lehman Brothers went bankrupt.
One time in 2009 I was impressing my then-girlfriend by showing her the gym in my building. I had obviously never been there before.
I lived right across the street from the New York Stock Exchange. I saw traders going in and out of there every day. Always depressed.
At the gym, some guy saw me and got off his treadmill and came up to me.
“I have to shake your hand,” he said. My girlfriend was watching.
“My group saw the bankruptcy pattern you wrote about in your book,” he said. “GM went bankrupt today. We made 100% in a few hours and called it a day. So thank you!”
I had forgotten to play my own strategy!
This strategy saved my life over and over again. The biggest opportunities for 100% returns or more are found by betting against irrational behavior.
The hard part is finding the patterns that consistently show you where investors are behaving badly.
And now it’s even harder! The markets are on an incredible 10-year streak.
“People Are Always Fearful. And People Are Always Greedy”
I know many hedge fund managers. Many bankers. And many billionaires have come on my podcast and told me their worst fears.
I ran into a friend of mine who bets on horses. We swapped techniques. “I do something similar,” he said. “I have data like the horses in the race, the track conditions, the prior races, etc. and then I make the high-probability bets.”
He runs a hedge fund doing this that makes about $30–50 million a year in profit.
People are always fearful. And people are always greedy. In every area of life. The markets, horses, relationships, elections.
Often, very often, every day even, they make irrational decisions because of that fear or greed. It might be on a stock (if Microsoft goes down four days in a row after an earnings report), or it might be on the market (like the patterns above).
Some of the patterns don’t last very long. Days or weeks. But others last for lifetimes. These are the ones I try to focus on.
Because of this strategy of using software and artificial intelligence techniques, I have saved my life, made money, started businesses, for the past 20 years.
And the environment is much more confusing, much more chaotic right now.
My #1 Rule
Hedge funds managing billions of dollars are forced to find irrational behavior only in super large opportunities so they can put in billions of dollars a day.
The software I write takes advantage of those big funds and the biases they code into their algorithms. They are forced to ignore the smaller, more nimble, more profitable opportunities.
Around 2003 I shared the software with a bunch of friends. Every morning they would look at the patterns in the market and send me what they thought was the best trade.
Then I would do my own testing, and tell them what trade I was doing based on the software.
Now, rather than doing a hedge fund, or day trading for a big firm, I wanted to share the software some other way.
I don’t want to start a hedge fund. That’s ugly work with ugly people.
Trading should free you from the desk, from anxiety, from the stress of watching every tick up or down in the market.
I wanted trading software from the future. I wake up and it tells me what to do. I make the trade and then I can go on with my life.
And then I found it… A pattern that worked again and again…
One that lasted about 7 days on average. So it would give regular people trading at home a window to invest (and NOT just computer software making a trillion trades per second).
The results have been spectacular.
My rule: I have to have patterns for up markets, sideways markets, down markets, booms and busts.
for The Daily Reckoning
Source: Daily Reckoning
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