I am currently reading and would recommend "Bull!" by Maggie Mahar for a longer term view on the stock market than many people today seem to consider it on.
The problem isn't that the non-random strategy did poorly, it's that it has too much exposure to needless sources of uncertainty. The inverse strategy doesn't get rid of uncertainty, it just flips the sign of their exposure to that uncertainty.
That was a very elegant way to make it click for me, thank you.
How is that the theoretical ideal when a few good stocks far outperform a maximally diversified portfolio?
The longer explanation is that you can break down the price effect of various real-world events into two axes. There are things that transfer market value between companies, and things that change the value of the market as a whole. For example, people buying more Macs instead of PCs will transfer market value from Microsoft (among others) to Apple. On the other hand, a novel form of efficient energy production will do more to increase overall economic activity.
The maximally market-cap weighted portfolio has diversified away the first axis of risk. Suppose company A, worth $500M, loses $50M of market cap to company B, worth $100M. If you own $500 of company A and $100 of company B, the $50 loss from owning company A stock is completely offset by owning $10 of company B stock. You're purely exposed to changes in the value of the economy as a whole, and have eliminated diversifiable risk from your portfolio.
If you can't benefit from taking on diversifiable risk, you're better off getting the same return at a lower level of risk by simply removing it.
Market cap lost to non-public companies will disappear from your portfolio.
Take a really simple portfolio... I buy (or go long on) 1 share of GOOG and 1 share of MSFT. Over a decade I make an average of a 7% return per annum, while the random strategy makes, 8%.
What exactly would the inverse of my strategy be? To go short on GOOG and MSFT? That would do even worse and in that case I'd actually lose money.
Stay vigilant out there traders, don't eat the 30% haircut that will be visiting global financial markets shortly.
I am not at all confident that anyone can predict when it will come well enough to avoid it.
Remember that the last 3 months of 2018 saw the market drop ~20%, only for it to recover over the next 3. Were you able to sell in September and buy at the bottom in December? Almost certainly not...
Alarms bells are ringing in this market... If your good at risk management and can initiate low cost perma-bearish positions, you will be rewarded heavily over the next year or so.
Alpha chasers that don't have risk management skills should just buy Bitcoin (dont sleep on this, the halvening is May 2020-ish). Dollar-Cost-Averaging will get you a decent entry price.
Warning: Bought more 120,130,140 AAPL puts in prep for next collapse, if your in my way, I will literally eat your lunch.
Good luck guys!
No, it would be to take 1 share of every stock except GOOG and MSFT and it would work (well, under the given assumptions and with random = 1 stock of every pick).
The reason why this doesn't work for the average person is because they don't have the infrastructure for it or they don't trade enough to get the commissions down to make it profitable. Shorting comes with additional fees.
Lets say you always have two companies, A and B. Each year one of them triples in value, the other loses all its value, but the loser gets recreated so you can invest in it again. Each year you get to distribute your funds.
Your original strategy is to invest everything in A every year. But after doing some simulations, you see that your current strategy makes you lose all your money within a few years since A will sooner or later make you lose all your money. Should you invert your current portfolio and only buy B? Of course not, both stocks are equivalent in isolation!
The best strategy is to allocate your funds 50/50, that way you double every year. Allocating each part of your money randomly would get close to this, so is still way better than just picking one or the other. What is important is to find stocks whose risks doesn't correlate with each other, since correlated risks will cost you a huge amount in times of down-turns.
You seem to assume "buy everything" to be the neutral strategy. Then everything plays out as you say.
Choosing not to allocate it is kind of irrelevant, just like "play tic-tac-toe instead" is not a chess strategy.
Stock-picking is specifically referring to where you should allocate a given amount if you are investing. There's obviously more to stocks than simply picking them, but as for picking specifically, there's no analog in poker because you don't divide your bet that way. (Aside from raising on a bluff, but that's stretching it).
Whether, when, and how much you should invest is a separate strategy that's related to your confidence and expected return of the picking strategy—but not the same thing.
Just like whether and when you agree to a game of chess vs tic-tac-toe might depend on your confidence in your skills; but that decision is _not_ relevant to chess strategy, which assumes you're already playing the game.
Buy nothing is not even a strategy. It's like calling empty set a neutral real number
Amateurs tend to pick uptrending correlated stocks (all stocks trending up in the U.S.). When U.S. economy crashes, all their eggs are in the same basket.
If you'd tell the amateurs to pick the inverse, they'd go for downtrending Chinese stocks. When China's economy crashes, all their eggs are still in the same basket.
I think what you are looking for instead, is contrarian trading strategies. Here you follow counterstrategies to what the large herd is doing. A good contrarian strategy for buying bitcoin, may be to gauge crypto sentiment on HackerNews. If the majority is gleeful or pessimistic, the price is too low for future value, if articles get posted on how to build your own blockchain in Python, then you should be ready to start converting to money, because one month later, every smart nephew's uncle fomo-bought and panic-sold the hype and caused a crash or depression. Similarly, if the U.S. president is glowing about the heated economy, and dismissive of China, this opens up new profitable options for contrarian traders (which are less risky/more informed than completely random or following the herd).
Then the inverse would be obvious. However, it's not immediately clear to me whether the claim holds that an inverse thus defined would perform better than the original strategy.
In addition, buying/selling is not a binary action per se for stocks because you need to specify an amount.
There is not one single non-random strategy. There are millions active at any moment. Which specific non-random strategy should we pick to assure success?