ETF Traders Can’t Win A Loser’s Game

In their 1978 song, “What a Fool Believes,” the Doobie Brothers spin a tale of a man who is self-deceived, trusting a lie of his own making. Somehow, this poor sap has convinced himself that he is a Casanova, the apple of some woman’s eye, when in fact he isn’t even a blip on her radar.

This fictitious character’s predicament is not much different from what many stock traders face. In love with the Wall Street fantasy of trouncing the markets through laser-like stock selection, such investors prefer to see themselves as a type of Warren Buffett — processing data with superhuman accuracy to distill the investment insight of the day.

Such investors have convinced themselves that their fantasy is in fact reality — that they can overcome a million I.Q. points, a throng of Ivy League MBAs, and software systems engineered by rocket scientists, and pick a needle of a winner out of a massive equity haystack.

Potholes on Wall Street

In his insightful “A Random Walk Down Wall Street,” Princeton University professor Burton Malkiel effectively argues for what economists call the efficient market hypothesis — that the price of equities reflect all the publicly traded information and thus are efficiently priced. In other words, there are so many intelligent and informed investors staring at both sides of the buy/sell ledger that it becomes a crap shoot to try to pick a stock’s direction based on your reading of the tea leaves.

Armed with the same information, struggling against market pros is daunting enough. However, traders aren’t armed with the same information. They have brought a knife to a gun battle.

The SEC is hotly pursing cases of rapid-fire trading, in which complex computer systems allow institutional groups to jump ahead of the average guy in an exchange’s “order book.”

Capable of anticipating that your trade is about to hit the system, these geniuses have found a way to front-run your activity, harvest a profit and get out in the blink of an eye. Such computerized trading now represents almost one-third of all daily exchange volume. To add injury to abuse, the SEC has discovered that these same rats earn rebates on their transactions from the exchanges even as regular investors pay fees to complete their trades.

Don’t believe that high frequency trading is Wall Street’s only advantage. In an effort to undo the efficient market hypothesis, Wall Street pros are always angling for bits of information the average guy can’t obtain. Competing against these traders is a fool’s errand. As the Las Vegas adage goes, “Look around the poker table; if you can’t spot the sucker, it’s you.”

So what is an investor to do? Quality ETFs provide an answer. Low in cost, highly diversified and tax efficient, these vehicles give the average investor more than a fighting chance to emerge from the fray a winner. With ETFs, investors own a bit of everything in proportion to their individual needs — in the next year, some of their holdings will rise and others will fall, but over time they will reap the rewards of participating in the free market’s productivity.

Smart investors own stocks from the U.S., through a fund such as Vanguard Total Stock Market ETF VTI -0.81% and around the world through funds such as Vanguard MSCI European ETF VGK -2.29% and Vanguard MSCI Pacific ETF VPL -0.85% .

In addition, they own bonds through Vanguard Total Bond Market ETF BND +0.19% , and get commodities exposure through SPDR Gold Shares GLD -1.19% and iShares S&P Global Energy IXC -1.24% , and real estate exposure in SPDR Dow Jones REITRWR -0.07% .

These investors have the discipline to trim what is going up and buy what is going down. Guided by a plan as opposed to intuition, they bought stocks when the S&P 500 Index SPX -0.77% crashed in 2009 and trimmed their bond holdings. Today, they’re adding to their bonds while trimming fast-rising stocks.

What does a fool believe? For the trader, it’s a fantasy of beating the pros. For those of us who prefer reality, using ETFs for low-cost indexing, asset allocation, and disciplined rebalancing is the game to play.