Why the average (DARWIN) investor will probably lose money.

The title of this blog post might put you on the wrong foot. Let there be no doubt: the Darwin Exchange is a true revolution in the asset management business. Both for profitable forex traders who want to scale their talent, as for investors who want to invest in the best trading strategies. Everything is in place to benefit everyone who joins this innovative project. But still, since I created my Darwin TSB in May 2014, there has occured an astonishing pattern with investors in my Darwin and I think other profitable traders may have noticed it too. It is so significant I felt the urge to warn investors, because understanding and anticipating this phenomenon may save and earn them a lot of money.

At time of writing (31/12/2017) my Darwin has a track record of almost 4 years. An investor that has invested since the beginning would now have a return on investment of 35.2 %. Not bad if you compare it to most other asset classes (given the relative limited risk darwin investors are exposed to and the current low volatility environment in those 4 years). So at least you might expect most investors of TSB had their piece of the pie with a decent return on investment. Let’s take a look.

For the purpose of this article, we don’t take into account the number of investors, but the amount of total investments. So every investor can make several investments. Since the launch of TSB there have been 76 investments. Only 7 of them are still running, 69 have been closed. Of those 69 closed investments, 42 lost the investor money (only 27 were profitable). The losing investments were 12.25% on average, while the winning investments only delivered 4.27%. 

First of all: most investors have closed their investment in a strategy that has been profitable over a period of 4 years (and in my humble opinion has lost none of its potential to be profitable in the future). Secondly: on average, losing investments were bigger than the winning ones. Although I did not take into account that for every investor seperatly the image can be slightly different, the situation is clear. How is that possible? I analyzed the problem and did some research.

So here we go. It’s not so difficult to understand the mechanism behind investing in almost every asset class when it comes to profitability. If an investor sells a certain asset class at a lower price than he bought it, he takes a loss. If he sells at a higher price, he makes a profit. So despite my Darwin being up 35.2 % in 4 years, most investors choose to sell, and more surprising: sell lower than they bought. So here comes the logical question: why do they do this?

 

Comparison with investing in stocks.

 

To find a profound answer to this question, I looked up some research of investing behavior in other asset classes. I got a lot of information to solve this puzzle from research of investing in the stock market. First of all it is important to consider if we can generalize research from the stock market to investing in Darwins on the Darwin Exchange.

 

Darwins Vs. stocks

There is an important difference between the core characteristics of a stock and a Darwin. A stock is a share in a company that goes up and down in price because of supply and demand. Its intrinsic value comes from a lot of different factors: earnings, P/E, the management, external factors, share buybacks, competition with other companies,…

The price of a Darwin does not go up and down because of supply and demand of the Darwin itself. The price of a Darwin goes up and down together with trades a trader makes in the currency market (by which the exchange rate is determined by supply and demand, but that has no direct impact on the price of a Darwin). So in general we can say the intrinsic value for Darwins comes from the ability of the trader to make profitable currency trades in the underlying currency market in a consistent manner.

 

So can we generalize research from the stock market to Darwins?

I think we can say so. Prices of both assets are more volatile than their intrinsic value. For stocks, the price can change rapidly due to central banks decisions, rumours, macro events,… while the intrinsic value of the stock itself hasn’t changed a lot during the same time. Same for Darwins: a talented trader can make some bad trades in a row due to some unexpected market fluctuations or noise, while the talent of the trader does not change overnight.

And although investors of stocks influence the price of the underlying asset, and darwin investors do not, we can state that behavior (the choice to allocate capital or not, the timing of investing,…) has a profound influence on the potential profit investors can make with both assets.

 

The underlying causes of darwin investors preferring selling lower than they buy.

 

First let’s make the obvious assumption no investor of TSB has allocated capital because they hoped that my strategy will burn their cash. No investor allocates capital to a Darwin because they think it will perform badly in the future. So we can assume every investor was convinced of the fact that my Darwin was one of the best out of hundreds of Darwins they could choose from at the moment they invested. So what causes an investor to sell “their best Darwin in the world” and take a loss?

 

Investors give too much weight to past performance.

Research on investor behavior in hedge funds can give us great insights. It’s remarkable that investors in hedge funds chase (short term) performance to a large extent. That is, when a hedge fund manager performs well over a given period in time, more investors capital comes in. When a hedge fund manager performs badly over a given period in time, more investors capital leaves the fund. That’s astonishing if you know that research clearly indicates that past performance of hedge fund managers is a really bad predictor of future performance, certainly in the short run. Other variables like the traders temperament, the risk management applied, market momentum,… are far better predictors.

I’m pretty sure this phenomenon is also present with Darwin investors. And also the people behind Darwinex understand that performance, certainly in the short run, is not the best indicator of future performance.  There is a reason they put a lot of effort in making available other indicators, called attributes, for Darwin investors. And although I think many investors know that these attributes carry a great deal of significant information, performance probably still is the biggest decisive factor.

 

The recency bias.

The above cause of bad investing behavior is related to the next possible cause: the recency bias. This is a basic cognitive error that makes humans overemphasize recent events. It’s present in a lot of areas of human life, but in investing it has profound consequences.

A perfect example in everyday life is the fear people have and the measures taken by policy makers after a terror attack. The moment an attac happens, people immediately avoid crowded places and police patrols the streets. Another example is a plane crash. Immediately after a plain crash people avoid taking planes. Both examples prove people don’t react rational. There is absolutely no objective reason to be more afraid for dying in a terror attack immediately after one happened. And after a plane crash there is still far more chance to die in a car accident (actually a plane is one of the safest means of transportation).

Also in investing in almost every asset class, people put to much attention to what has happened in the short term. When people see going stocks go up for 5 % in the last week, they jump in, forgetting that markets went down for 50 % several times in the past (or when a market crash is happening, they sell everything, forgetting markets have always recovered their losses…).

The same is true for investing in Darwins. For example in my Darwin, losses were frequently taken right after my Darwin took a daily or weekly dive. Investors forgot that over a longer period of time, my Darwin always recovered those losses.

 

Follow the herd.

Actually this human behavior is one of the important reasons of market booms and busts. In situations where the outcome is unclear, people seek for confirmation and clues with other people. Basically, investing is trying to forecast an uncertain future and it is extremely difficult to do. While trying to do this, people look to each other, or ‘market wizards, gurus, financial experts,…’ to form decisions or confirm their own beliefs. Even when people objectively know other people don’t have a clue either, they intuitively still seem to think: a bad clue is better than no clue. This also relates to the fact many great investors are independent thinkers. They also have build up enough self esteem to not let their own analysis questioned by others.

Would this be of importance for Darwin investors? Well, simply look to the rapid increase or decrease in amount of investors a certain Darwin gets over a short amount of time, the so called “trending” Darwins. Would all these investors have made their own, individual, objective analysis, totally independent from others, of the Darwin they allocate capital to? I think herd behavior might be an important factor.

 

Humans are genetically wired to be poor investors.

This might be the most depressing cause for bad investment decisions. Even when people try their best to overcome all investing obstacles, research suggests investing decisions are genitically determined to a large extent. We are wired to seek safety and avoid danger as much as possible. Apart from that, research also suggests that investors actually feel pain when an investment turns bad. Their only way out is to sell (probably at the worst possible moment…).

Our perfection in this kind of behavior is maybe one of the most important reasons why we excel in surviving. But it is clear it does us no good when we invest in almost any market. So although you might think you can learn to be the greatest investor of all times, mother nature might have decided otherwise.

 

Conclusion

 

The average Darwin investors probably is no different from any other investor / speculator in any other asset class making the wrong choices, even considering Darwinex provides several tools (attributes, risk management, rewarding and promoting the best traders…). The solution is not immediately at hand. Darwinex could push investors to do the right things (warn investors when they close a Darwin too early, draw more attention to attributes than to performance, not show the amount of investors…). I think there is something to say for Darwinex guiding investors on how to pick the best Darwins, but pushing it too far will be the end of Darwin Exchange perceived as being neutral (and scare some valuable traders away from the exchange).

I think considering all the above possible obstacles everytime you buy and sell darwins (or other assets) might be the important first step. Basically everything begins with knowledge and a very profound, deep, value analysis of the Darwin you are allocating your capital to. Simply have a structured but flexible plan and stick to it at all times. Set clear rules of what you will do when every possible situation occurs. How to do this? Well, the value analysis of Darwins will be matter for a future blog plost.

To conclude: I think, unfortunately, most investors will learn it the hard way. Some will fall, learn, and return to be the best investor. Some will simply quit. Others maybe will have read this blog post and avoid a lot of needless losses.