The Illusion of Control and the Role of Luck in Trading

 

Many statistics based on the performance of hedge funds have led to the conclusion that it is impossible to achieve consistently superior profits in the market through rules or formulas, as these are no better than a diversified investment structure chosen at random. This has prompted financial theorists to explore why a well-functioning financial market naturally eliminates excessively high profits over extended periods. The Efficient Market Hypothesis (EMH) provides one explanation.

An efficient market is one where, at any given time, all new information is immediately captured by market participants and reflected in market prices. This leads to a random walk, where market prices fluctuate unpredictably and cannot be forecasted over time. Studies of stock price indices, both for entire markets and individual assets, reveal that their movement charts resemble the outcomes of flipping a coin at random.

Although I disagree with the notion that markets are fully efficient, I do not dismiss the idea that prices operate randomly. In fact, randomness governs many phenomena around us, originating from the smallest quantum particles. This randomness may not be something mystical but rather a reflection of our limited computational capabilities and the lack of sufficiently robust models to fully capture and understand it.

If we take the daily closing prices of a stock (or asset) over the long term and arrange them based on their percentage changes from the previous day (starting from the largest decline to the largest increase) and plot their frequencies on a chart, we would obtain a probability density function of returns (see the chart below). Each price chart represents a random distribution of these changes over time. From a probability density function, it is possible to generate multiple different price series. As a result, the price movements we’ve observed in the past are not the only possible scenario that could have occurred.

In trading, the illusion of control is a phenomenon where a trader believes they have complete control over their outcomes. They think they fully understand the market and can dominate it after achieving some level of success. In reality, trading is not solely a game of skill but also a game influenced by luck.

The "monkey and typewriter theorem" is a fascinating metaphor that illustrates this concept. The theorem states that if a monkey randomly hits keys on a typewriter for an infinite amount of time, it could eventually produce a literary masterpiece purely by chance. Similarly, in trading, even an inexperienced trader can achieve significant profits solely due to luck. However, this does not mean they have the ability to replicate that success consistently.

The illustration above shows the account growth of a trader who appeared to have generated consistent profits over nearly five years, trading exclusively in Bitcoin during that time. But can he continue to replicate this success? As we know, randomness can create a multitude of different price movement scenarios. It’s possible that his trading strategy just happened to align well with the market conditions over those five years.

Now, let’s imagine history played out differently—prices formed alternative structures and moved differently. To test this, I applied the same trading strategy to a price chart with a different movement structure. As shown in the chart below, the trader completely failed to generate any profits. Despite using the exact same trading approach, he was unable to achieve the same success.

This trading strategy might indeed be a good one, but the final outcome doesn’t just depend on how the strategy functions. It also heavily relies on luck, the market structure, and the price movements in both the present and future. If the previous example hasn’t convinced you of the significant role luck plays in trading, let’s imagine the following experiment:

We select 100,000 traders with poor skills and no trading edge, but they are highly determined to make money. These traders each have a capital of 50,000 USD (possibly borrowed, gifted by parents, or saved). If they fail, they won’t get a second chance to try again. To simplify and generalize their performance, we evaluate their results over a 5-year period.

Since they lack skill, their probability of success and failure is as follows:

• A 40% chance to double their capital in one year.

• A 60% chance to lose all their capital.

Using the expected return formula, it’s clear that these traders are operating with a negative expected value.

After the first year, 40,000 traders will have doubled their assets to 100,000 USD, while 60,000 traders fail.

In the second year, 40% of the 40,000, or 16,000 traders, will double their assets to 200,000 USD, leaving 24,000 traders to fail.

In the third year, 6,400 traders will have 400,000 USD.

In the fourth year, 2,560 traders will grow their assets to 800,000 USD.

Finally, by the fifth year, 1,024 traders will have accumulated 1,600,000 USD, making them millionaires in USD terms.

This means 1,024 traders out of the original 100,000 have become millionaires. However, their profits are clearly the result of pure luck, not skill or trading expertise.

To achieve sustainable success in trading, it is crucial to acknowledge the existence of randomness and the influence of luck, while letting go of the illusion of control. A truly wise trader understands that it is impossible to always predict the market accurately and that profits are often the result of sheer luck. This awareness helps them remain grounded and prevents overconfidence following a streak of success.

Always remember that we can never know the exact outcomes we will achieve, and no strategy can guarantee profits in the future. Instead of trying to control trading results completely, we should focus on risk management measures to minimize losses when the market moves against our expectations, while adopting a more long-term mindset.

One of the most important risk management methods is to set a stop-loss level for every trade. Stop-loss orders help limit the maximum loss a trader can endure, ensuring that a single unsuccessful trade does not have a significant impact on the entire account.

Another crucial method is diversifying the trading portfolio. This means trading across multiple asset classes or employing different strategies to avoid relying on a single lucky scenario. The more positive-expectancy trading systems you have, the better your ability to adapt to changing market conditions.

In a specific period, one system may perform well in a certain market, but during a different period or in another market, it might fail. Diversification ensures you have alternative systems to fall back on, reducing the overall risk and increasing the likelihood of long-term success.

In summary, success in trading is not solely dependent on skill or analysis but is also heavily influenced by randomness and luck. Instead of being trapped in the illusion of control, traders should focus on risk management, maintain discipline, and be mentally prepared to handle unexpected market fluctuations. Recognizing the ever-present role of randomness allows traders to adopt a wiser and more realistic approach, ultimately enabling them to build sustainable trading strategies.