To start off, I would like you to imagine the following scenario: you are the goalkeeper of the Montreal Impact, a Major League Soccer (MLS) soccer team.
In the first game of the MLS Eastern Conference Final, the Impact faces Toronto FC in front of more than 60,000 people at the Olympic Stadium. With the score tied, you must face a penalty kick; a showdown between you and a player from the opposing team. Given the size of the net and the fact that the kicker is 11 meters away with a ball traveling at nearly 130 kilometers per hour, the chances of a goal being scored are 75%. To increase your probability of success, you must quickly choose one of the following three options: dive to the left, stay in the center of the net, or throw yourself to the right. Which strategy do you choose?
According to Steven D. Levitt and Stephen J. Dubner, authors of the book Think Like a Freak, the goalkeeper remains in the center only 2% of the time, even though 17% of all kicks are aimed there. So why doesn't he stay in the center more often?
The answer is: because he's scared that this will be perceived as a lack of effort. If he stays in the center and the shot goes to the left or right, chances are that he'll be disgraced in front of his teammates, the crowd and the thousands of viewers watching him. And although his decision may seem sensible in terms of probability, in the eyes of everyone else, this tactic will be seen as passive. In my opinion, the principle of effort over outcome applies as much to the stock market as it does to sports.
Remorse is the best incentive to do nothing.
Undoubtedly, for an active trader, the US presidential election was an event as decisive as a penalty kick in soccer. In fact, regardless of the outcome of the vote, the financial community expected higher market volatility. To take full advantage of this, active traders had to react quickly, like a soccer goalie. Given the fact that many financial experts anticipated a severe stock market correction in the event of a surprise victory by Donald Trump, it was natural to reduce equity exposure the day after the election. In doing so, active traders hoped to make the right decision and, in addition, felt that they had made an effort since logic dictates that it is necessary to be active during periods of strong stock market fluctuations.
Unfortunately, it would have been better to maintain one's equity investments, as the S&P 500, NASDAQ and Dow Jones Industrial Average all rallied to historic highs by the end of November. Since it was impossible to predict the outcome of the election and, above all, the reaction of market participants, the passive approach of doing nothing was appropriate. According to an analysis of 66,000 reduced commission brokerage accounts, a high number of transactions significantly reduces performance. Between 1991 and 1996, the best 20% of the most active investors generated an average annual return of 11.4%, compared to 18.5% for the 20% of least active investors and 17.9% for the S&P 500.
Instead of trying to predict market direction at major events such as the Brexit or the US presidential election, active traders must rely more on probabilities, which entails a more passive behavior. To do this, like the soccer goalie, they must remain "centered" on their objective to make an optimal decision.