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Trading Is Hazardous to Your Wealth [pdf] (2000) (haas.berkeley.edu)
72 points by alokrai on May 14, 2020 | hide | past | favorite | 113 comments

If markets were truly random, you might expect 50% of day traders to lose money, not 90%. Of course, markets are not random and most untrained humans have emotional biases that actively optimize for losing money in markets.

This is likely a controversial opinion: 90% of the time, someone who wants to break out of the "rat race" or achieve wealth for some future vision should go the startup route, or if the wealth part is not as important, do freelance/consulting. However, I believe there are 10% of people where trading the markets provide the better way to achieve the same goal. The reason being that for certain personality types (you need to be smart, disciplined, and creative to beat the market, and it still requires a lot of time), I suspect trading offers a higher expected value of return than starting a bootstrapped company. Startups, especially those not started by someone wealthy, have a higher failure rate than day traders. If you are not passionate about anything you can get funding for (would SpaceX have been successful if it were Elon's first company?), and you fit the criteria, trading is not as terrible an option as its reputation suggests.

Two counterarguments:

1) Trading fees. If the house takes a cut of 0.1% on every transaction, then on average those who trade more lose more money.

2) Risk/reward tradeoff. If you buy deep out-of-the-money options, you might have a 5% chance of profitability, but expected return of $0 (neither positive nor negative). 95% of the time you lose $X, and 5% of the time you make $19X. If traders are pursuing riskier strategies, you'd expect most of them to lose money.

Trading fees are a valid counterargument here, and while they are non-negligible (especially back when the "90% of day traders lose money" rule was established), I don't think they account for the full 40%.

For point 2, if there is an expected return of 0, then on average this should push the portfolio toward 50% chance of profitability.

It is the psychological factors combined with a non-random market that ensure most traders lock in losses (usually after riding them too long or not long enough).

If I roll a 100-sided dice that pays me $99 if I roll a 1 and -$1 if I roll 2-100, then my expected value is $0, but my chance of profitability is 1%.

He's saying that traders don't just make 1 bet in their lifetimes though.

True, but you have to account for the chance of ruin. Once you go broke, you have to stop betting. Many traders will continue betting larger and larger amounts of money when they win, but stop betting if they lose big. Making risky bets is quite likely to make you go broke, especially if you scale the size of your bets with the size of your bankroll. The [Kelly Criterion](https://en.wikipedia.org/wiki/Kelly_criterion) is the best way to approach it.

Also, the average at-home trader probably doesn't sell at a random point in time. They are probably more likely to sell after a loss.

It's often the opposite which is responsible for poor trading performance, due to the fundamental anomaly of markets: trends. Poor traders don't let winners ride and let losers ride to get above their break-even point, which often results in huge losses betting against the trend.

> Trading fees. If the house takes a cut of 0.1% on every transaction, then on average those who trade more lose more money.

If you trade derivatives, fees can be very low (because these are highly-leveraged products but if you are smart you know you shouldn't take any leverage). This can save substantial money if you trade frequently.

> Risk/reward tradeoff. If you buy deep out-of-the-money options, you might have a 5% chance of profitability, but expected return of $0 (neither positive nor negative). 95% of the time you lose $X, and 5% of the time you make $19X. If traders are pursuing riskier strategies, you'd expect most of them to lose money.

There is more to trading than predicting the direction of a stock/currency. You can provide liquidity and arbitrage a stock and its derivatives. Having traded for a while, arbitrage opportunities do exist; though sometimes you might have to be patient and cut off trading until an opportunity arise. This can be quite a time (like a year with no trading opportunity) and will require a lot of self-control.

This is not why the 90/50 contrast exists.

It exist due to "absorption barriers", due to the ergodicity of the process - betting too big and hitting "uncle points".

It's a bias present in most people, especially otherwise intelligent people: not understanding that there is a huge difference between expected value and ergodic properties. Between expected returns and risk. Just look up what VaR is, the concept is ridiculous, yet so widely used.

How much should the win (5/6) value be in a game of Russian roulette for you to play the game? The answer is that for most people it is not any number, that value doesn't exist.

Don't underestimate how many people are on the brink of suicide anyway, and where a 1/6 chance of the good life seems like a good deal. Oh wait 5/6. Well that just makes it even better.

>not understanding that there is a huge difference between expected value and ergodic properties

Can you expand on this? Are you claiming that the stock market is ergodic, or that it is not?

This applies much mote to actors within a securities market (both investors and issuers), not necessarily to this or that market itself. Most people's behavior is non ergodic.

Though I suppose even if you broaden "the market" even to all of civilization - it is also non-ergodic, at least since nukes and hydrogen bombs were created.

Great point! The "uncle point" is a great phrase I hadn't known before.

You may be interested in Nassim Taleb's terribly written but actually very significant intellectual output.

This is absolutely right. I'm handily beating the market with an automated strategy I designed to the point I've all but shut down my startup/programming consulting business. What the system trades, and what I understand intellectually is the right thing to do, is often very hard to stomach emotionally.

Do you have a background in finance / any recommended reading?

I've spent a lot of time on a automated trading side project of mine but haven't found the strategy yet.

In retrospect time has been spent in completely the wrong areas ( setup a solid backrest platform first, duh )

My favorite is Ernie Chen's "Quantitative Trading: How to Build Your Own Algorithmic Trading Business" https://www.amazon.com/Quantitative-Trading-Build-Algorithmi...

Warning: it is a lot of fun, thrilling, but hard to make money. My winning algos took a while to research, longer to automate, and often lost alpha quickly.

It was a big part of my degree but I never worked in finance professionally.

Backtesting is great for validating ideas initially. Especially, to see if it holds up through abnormal markets like '08, or the volpocalypse, or the recent crash. Watch out for curve fitting, though.

Thanks for the reply. Yeah I needed to nail that down immediately!

Do you apply ml techniques? I don't suppose you could point a little in a good direction to follow

I don't. But, I've been playing with a few ideas using that. I suspect ML is mostly complicated curve fitting.

Something like using NLP on SEC filings the second they come out to catch an initial jump in the underlying would be cool to try out.

May I ask how you got started? What is the tech stack you are using today? Any resources you can recommend?

Sure. I graduated with a business degree (b.s. in management, specifically) and just kept on learning everything I could get my hands on about finance, valuing derivatives, human behavior and biases, etc, on the side through a couple of different careers. I used to bring Buffett's shareholder letters on trips when I was a pilot, for example. I've been a big nerd about this stuff for a long time and the strategy I built is the culmination of knowledge from a wide range of experiences and studying all fitted to my personality and goals.

Tech stack: I love Ruby, but use Python and a custom language that interfaces with the broker I'm using for execution. More and more decent broker API's are starting to pop up out there. So, you can likely use whatever you're most comfortable with. Alpaca has a decent web API, for example.

I honestly wouldn't recommend getting into it, though, unless you really enjoy geeking out over this stuff and have a decent breadth of knowledge to find your edge. You're also competing against some brilliant PhD types who are just as obsessed and hard working as you. My stuff works in part because it's taking advantage of some things that are too small for the big boys to pay attention to.

What platform do you trade on?

Interactive Brokers. They have an API. I started 10yrs ago back when they were the only player in the market to offer $1 trades. Making money is hard though, and probably not worth the effort if you account for your time. But it was a lot of fun and I learned a lot. I imagine if I did it full time, I could be more successful.

A lot of day traders use leverage. As a result any sufficienty large downward move will result in a margin call and they have to take the loss. Being correct about the overall direction but having bad timing is the same as being wrong.

And it's not even that day traders' decisions are wrong. It's just that they're predictable in advance by HFTs who can act on news stories within milliseconds, so they're always buying after the uptick and selling after the downtick.

If they keep losing they are wrong or at least playing the wrong game in trying to play John Henry with a computer in fluctuations.

They need to compete like a human - using their pattern matching skills and reason on the fundamentals. Algorithmic traders that attempt sentiment analysis get fooled into doing things like buying Nintendo stock because female Bowser art was trending.

If markets were truly random, I'd expect (approaching) 100% of day traders to lose money (or gain 0), because the expected value is 0. It's like betting on a coin flip. Since we're at 90%, it's pretty close.

Huh? Doesn't your argument also mean that you'd expect nearly 100% to make money, or lose 0?

Yep, that is a fairly common misunderstanding that the general public makes (and ends up with: if I just take the opposite decision then I will make money).

The main reason why 90% lose money is costs. That is it. Most people probably are optimised for losing money but the main issue is really costs/overtrading.

But related to this, most people believe that edge on profitable trades is very large...but in most markets, institutional-grade costs will still be a big chunk of your edge i.e. costs matter hugely.

Costs? as in commissions? I haven't paid a commission in two years. Many brokers are now commission-free.

if it's commission free, it's likely because (1) fees are baked into the quoted price, or (2) firms are buffering trades with their own holdings and making money on traders' losses. you're paying somewhere for sure.

Sort of.

The fees are baked into quoted price ("the spread") but the execution cannot be worst than the NBBO (National Best Bid Offer).

They are making money on the spread for sure, probably crossing some trades internally as well. They also make money on the margin rates.

Yeah, but the NBBO moves.

You don't think it's at all strange that 80% of share volume coming out of Robinhood is sold off to broker-dealers attached to large systematic hedge funds?

I'm sure you could think of a thing or two to do with terabytes of retail trade logs and behavioral advertising data.

>> Yeah, but the NBBO moves.

The rule is that at the time of the execution, the execution cannot be worse than the NBBO.

I'm dont work at a broker dealer anymore, i'm a retail investor. I think where we are is awesome. Ten years ago, these trades cost $7 to $20 ($1 for iB) + spread.

Twenty years ago, they cost $10 to $50 + spread.

Twenty five years ago they cost $35+ + spread.

These numbers are not even inflation adjusted. In think where we are is awesome and a big win for customers.

I'm not saying things aren't better now than they were in 2000.

I'm just saying that systematic hedge funds make directional bets and hold positions overnight. These activities move the midpoint.

That is a hidden cost not visible in spreads or commissions. The SEC can't even measure that cost, only the intermediaries themselves can.

>If markets were truly random, you might expect 50% of day traders to lose money, not 90%.

Only if the humans were making decision to buy and sell randomly.

Intuitively, I don't think this is necessarily true. It probably depends on the type of random distribution for price movements.

More the magnitude of randomness in the total vs "ordered" growth. A truly random stock market would imply an utterly insane economy (avoiding the obvious jokes for now). A company with good current and future prospects that everyone knows going down over time continually while a doomed one rises? One at a time maybe from "glitches" or extreme circumstances. Like say a massive need for short term funds and more ending shorting than available shares to cover it and a margin call chain for the latter. Both at once? Likely impossible even with extremely weird economic circumstances which make the COVID-19 economy look perfectly normal.

> I suspect trading offers a higher expected value of return than starting a bootstrapped company. Startups, especially those not started by someone wealthy, have a higher failure rate than day traders

This seems highly unlikely

Sure, there are people that have the skillset and capital to earn a living from day trading that don't have the skillset or interest in running a business who'll be better off trading. But successful businesses selling products or services can consistently earn very large multiples of their initial investment, and day traders can't. Short term financial bets are much closer to a zero sum game than starting businesses. And we've already established that 90% of day traders fail, just like startup businesses. More than 90% since the criteria in this study is beat the index, not earn a living.

As a day trader, you are always one trade away from losing it all.Even if you're diversified, one major loss can be devastating.

I read an article a few years ago that compared the trading performance of various strategies. The number one performer was the "dead people" strategy, which happens when a person dies and his portfolio cannot be traded while the inheritance issues are sorted out. Next best is the broad index fund, and dead last was the average investor.

Edit: Found the article!


And tunneling far below that was /r/wallstreetbets

What’s the difference between the dead person strategy and an index fund? The dead strategy involves whatever stocks they had selected at the time?

The dead person can't make bad decisions on when to buy/sell the index fund. Those "bad" decisions don't even require an attempt to time the market, if e.g. you always invest whatever's left over after ~fixed living expenses, and you get paid more when the market's higher.

Index funds have a deterministic algorithm to balance the portfolio. Hedge funds can predict this and always be slightly ahead. So whenever an index fund's algorithm says to buy more of something, a hedge fund probably bought it a fraction of a second ago and will now sell it to the index fund at a slightly higher price.

At least, version 1 of hedge funds did this to version 1 of index funds. It's now so complicated that all you can count on is the smartest, fastest-moving guys having a slight edge.

Even index funds have management fees. They're very low now, to the point of not mattering a lot, but it would still explain the ranking.

There's some other interesting effects with index funds too. Sometimes the price of ETF index funds gets out of whack with the actual holdings. When that happens, there are corrections that get brokered with well bank-rolled partners. This probably accounts for a bit of performance loss as well.

> Trading costs are high. The average round-trip trade in excess of $1,000 costs three percent in commissions and one percent in bid-ask spread.

A lot has changed in 20 years. The conclusion may still be the same, but spreads are much tighter (thanks in part to HFT) and trade commissions no longer exist.

I think it's important to point out that the conclusions are definitely still the same despite the lowering of trading costs since 2000.

Trading is hazardous to your wealth, period.

I'm not here to make a case one way or the other, but I would point out the graph at the top of the page numbered 775.

Most of the reported difference in net performance is due to the impact of commissions and spreads: As trading goes up, gross return was not impacted, but net return was.

Retail investors in 2000 were getting fleeced. (And if you think that's bad, take a look at commissions in 1980.)

Trading used to involve a lot more labor; it makes sense that the commissions have dropped.

You're not wrong about the 1980 comp but by 2000 this was automated and very, very profitable for brokerages.

Which is solely due to the extra cost of short term capital gains tax.

Trading also subjects you to short term capital gains tax rates, as well as losing the effects of compounding.

>> Trading also subjects you to short term capital gains tax rates, as well as losing the effects of compounding.

And judging from the rest of the comments, sounds like there will be lots of short term capital losses also to offset the gains. Also sounds like having lots of taxable gains might be a pretty good scenario here!

Short term capital gains rates have been 15%, right? Which is, based on my last gander at the tax charts, less than the regular w2 tax rate bracket many successful traders would file under.

No, short-term capital gains are taxed at your marginal income tax rates. 15% is for long-term capital gains below $500k.

Yes, and that is also lower now than it was in 2000!

> trade commissions no longer exist

In US.

> Berkeley.edu.

Not in any way defending day trading, but I think it's interesting that it's become such accepted wisdom about how bad it is- here on a website dedicated to startups. 90% of day traders lose money, what are the odds for startup founders? Probably more than 90% fail, yeah?

Imagine if, within the next 20 years, it becomes normal & accepted wisdom that joining a startup and taking their basically worthless 'equity' is more likely to lose you money than day trading. Just kind of an interesting juxtaposition- Hacker News, Website Devoted To Risky Startups, Decries Risky Day Trading

Not really a fair comparison.

Stock Market: you have access to the cap table, debt, overhang, etc.

Startup Equity: Unknown denominator. Unknown multipliers.

Stock Market: you can sell almost any time (unless you're trading penny stocks, etc.)

Startup Equity: you wait for a liquidity event, or hope your company is large enough to have an active secondary market.

Stock Market: you can buy/sell at any time

Startup Equity: you have the privilege of exercising an option into IL-liquid holding that you pay for now (sometimes forced to if you leave the company) but have little idea of the future value of.

To be fair, i'm working at a startup, I left a public company to do so. I'm here because I have huge impact on my product, I'm learning more, have more impact at the company level, low BS, low regulatory strangle, dynamic team, etc. I think it is rare to have positive expected value on startup equity unless 1. You are the founder or 2. It is a pre-IPO company. Your odds are probably better buying out-of-money NASDAQ Compsite options.

You don't work at a startup to make more money, you work at a startup for non-monetary benefits and if you're extremely lucky you might get rich quick. Average case is you make less, good case is you make even if your company is highly successful.

Without pointing any specific fingers, people were pushing 'you should spend your 20s working 60-80 hours a week at a startup so you can get rich' really hard for a while there. It's only relatively recently that this is understood to be a bit of a con

>> It's only relatively recently that this is understood to be a bit of a con

This go-around, there is a lot of private capital, so companies stay private for a decade or longer and lock employees out of liquidity events (meanwhile, founders can negotiate to take some cash off the table during a financing round.) The incentives are skewed. In the 90s bubble, companies with a $50M valuations could go IPO -- you could hopefully sell after your lockout. (Oh, and houses cost a tenth of what they do now.)

This go-around, there is HN, Quora, Blind, and so it is harder for people to get suckered into starry visions.

That said, it is still worth considering working at startups for the high-learning, low-BS environments you can find as compared to big companies.

> that joining a startup and taking their basically worthless 'equity' is more likely to lose you money than day trading.

How is that not obvious already?

I agree, I just think capital feels more tangible and riskier to lose than opportunity cost. Also easier to put a specific number to so easier to quantify the risk.

Only a small number of people are really good at any given thing, funny how people just forget this when a specific industry is being scrutinized.

Your making me glad I've been day trading instead of founding a new startup.

Can someone explain to me why people keep referring to average return as some sort of magical answer to the question? The median person makes the median income, that doesn't mean that trying to get a good job is pointless.

By definition in order for you to make more than the market, someone else has to make less than the market.

Assuming that knowledge has superlinear returns (I consider this to be obvious without proof required), of course less than 50% of participants will 'win' - those at the bottom are totally useless and burning money, whilst those at the top are quite skilled indeed.

It's fair to say that one should not expect to be in that upper echelon, but I don't think it's reasonable to state 'most people lose' and just leave it at that, it's blindingly obvious that most people lose, it would be impossible for them to not.

(Adjusted for balances - a guy with 20 billion quid can lose 1 pound each to 7 billion market participants and in that case 'almost everyone wins more than the market')

a lot is stacked against you as a private investor. being very smart is not enough to beat the market consistently when your competition is other very smart people who themselves have a support staff of very smart people and they all spend 8+ hours a day analyzing the market and making trades.

even if you quit your day job to trade full-time, they can collect information in ways that you can't (eg, satellite imagery), and they may also have direct lines to an exchange to execute trades faster than you. unlike you, they trade in large enough volume that they can get people to pick up the phone to trade after the exchange closes. they have access to entire classes of investments that are closed to you due to capital requirements.


I would argue that working for an institution that gives you access to satellite imagery also implies you can’t really play below a certain threshold of volume.

Otherwise it’s like hunting deer with a ballistic missile: you will kill the deer, but for that money you could have raised a whole tribe of them.

A related blog post: "Why I don't trade stocks and (probably) neither should you" http://edmarkovich.blogspot.com/2013/12/why-i-dont-trade-sto...

And consider also, "The 15-Stock Diversification Myth," http://www.efficientfrontier.com/ef/900/15st.htm :

> One of the most dangerous investment chestnuts is the idea that you can successfully diversify your portfolio with a relatively small number of stocks, the magic number usually being about 15.

> …

> The reason is simple: a grossly disproportionate fraction of the total return came from a very few "superstocks" like Dell Computer, which increased in value over 550 times. If you didn’t have one of the half-dozen or so of these in your portfolio, then you badly lagged the market.

there is a lower bound, but it's closer to 60, and those need to be picked carefully to avoid excess correlation. at that point, you might as well buy an index fund since you're unlikely to beat the market anyway.

On average. Also on average, starting a business is hazardous to your wealth, it's likely to fail. On average, don't do competitive sports, you're likely to lose.

Maybe 'Less Than Excellent Trading Is Hazardous to Your Wealth'? Don't do a trade unless you have an excellent advantage on it...

It's my understanding that, if commissions are free (e.g. Robinhood) then on average, any trading strategy is going to perform comparable to the market average.

If you can find any reliably bad strategy (in a fee-less market), then you have necessarily found an outperforming strategy that is the opposite.

First, that's true-ish in an expected value sense, not a Sharpe ratio sense. Even then, it's true only neglecting bid-ask spread (if you take liquidity) or adverse selection (otherwise). But the big effect is behavioral, that for the average person, if you can stomach actually implementing a strategy with your own money then that increases the chance it's a loser.

You can reliably lose money in absence of commissions by buying at the ask and selling at the bid. You can't invert that to make money.

You can invert it by becoming a market maker, though you'll need some heavy tech for that.

Your theory only works with a perfectly efficient market. In practice, even without commissions, there are many other sources of inefficiency in the market that act to reduce your returns every time you trade.

The bid/ask spread is an example of such an inefficiency. Take a hypothetical case where you just buy and sell the exact same stock over and over, but the price of the stock never changes. Every time you complete a bid or sell order, you would lose an amount equal to the gap between the bid and ask prices. Repeat the cycle enough times, and you will lose all your money, but the stock price will never have changed. What's the opposite of this strategy? To never trade at all?

The idea that you can just reverse a losing trading strategy to come up with a winning strategy is absurd, because it completely disregards the entropy inherent to an inefficient system.

> What's the opposite of this strategy?

Being the market maker creating that spread. Who also gets financial incentives from the exchange for doing so.

Eh, if I wanted bankrupt a trading account by playing a reliably bad strategy, I'd buy deep out-of-the-money options expiring this Friday. The expected value is $0 (neither positive nor negative), but they have only a miniscule probability of profitability.

The idea of buying deep OTM options is that they are 1. cheap 2. still have the possibility of turning green prior to expiry.

When you say "expected value" are you trying to say most likely value?

No, I mean the mathematical mean, not mode. If you take this action infinitely many times, what is your average (mean) return? https://en.wikipedia.org/wiki/Expected_value

I see, so you're saying the expected profit on the trade is $0 assuming an efficient market and ignoring trading costs? Your comment is confusing the way it's worded because the expected value of the option is non-zero.

Ah, sorry for that. I meant E[return on option - cost of option] ~= 0.

not any strategy, but any strategy that's reasonably close to the efficient frontier of possible portfolios.

actually, on average, all strategies will perform the same as the market.

another way of saying this is: the average of all trading strategies is the market.

That's not a helpful way of looking at things since individuals do not trade the average strategy. They trade whatever theory they are seeking to validate, which is too often "their gut" or the latest technical analysis woo. These people are cannon fodder for algorithmic traders and market makers. The average of all retail trader strategies is definitely not the market.

no, most strategies necessarily will be losers if not near the efficient frontier. trades average out to the market.

the parent, maybe mistakenly, stated any strategy will have average returns, but consider the naive strategy of putting all of your money in a small number of (often highly correlated) stocks. that trading strategy will underperform the market on average.

The biggest problem with trading is unrealistic expectations.

If people believed they could become a medical doctor by taking a weekend boot camp, you would see extremely high failure rates.

But that high failure rate would not suggest that it’s impossible to become a doctor.

Same with trading, if a person thinks they will make a few trades as their side hobby, it’s going to go about as well as the hobbyist surgeon. But if you’re obsessed with trading for a decade you can become quite competent.

Studies have shown it takes about 3 years of constant trading to develop a sense or intuition about markets.

Trading is just connecting buyers with sellers and pocketing a spread. It’s been a most profitable activity for a long time. You just have to optimize the carrying costs and manage risk. but it’s the same thing everywhere, being average is useless in wide competition. You need an edge: be smarter, faster, better capitalized, better connected, informed etc...

The more access the average joe has to the market the more seemingly plausible the idea that it's "impossible" to beat the market. No, it's just really hard. Just because most sculptures are statistically made with playdough doesn't mean it's impossible to create a great sculpture.

The best comparison anyone's made here is competitive sports. Most traders are doing the skill equivalent of shooting free throws in their yard; this doesn't mean there are not professional NBA players.

I don't trade individual stocks, I don't know enough. But I do buy ETFs, which are ran by people that [theoretically] do know enough. As an experiment I bought in after the March crash on a few ETFs that got hit hard. I'm pacing with the index which is good enough I guess.

Notes they're including this: "In aggregate, round-trip trades cost about one percent for the bid-ask spread and about 1.4 percent in commissions." Not necessarily the case anymore. The spread on apple is 0.04 cents on $300.

why do people think trading will make you rich?

Because of posts like these:




Most people do not fully internalize survivorship bias and are tempted to jump in on the easy money.

Same reason people think the lotto will make you rich. They see one person do it and think that can be them.

Because there are some very rich traders, including the fourth-richest person in the world.

he's an investor, not a trader, and has outsized influence on the outcomes of his investments.

A distinction without a difference. He is an active trader that moves in and out of businesses all the time.

In fact, he just dumped all of his airline stock recently due to Covid-19.

It doesn't matter if you trade based on research or not, you're still a trader.

au contraire, it's precisely the most carnal difference, that of intent and of effect. investors want investments--the companies--to succeed, and thereby externalizes a net positive societal effect; traders want their bets to succeed, others be damned.

Who is that?

Warren Buffet

Who is not a trader.

See XKCD "Survivorship Bias":

* https://xkcd.com/1827/

Cognitive biases play a large role in poor investment performance, see "Thinking Fast and Slow" by Daniel Kahneman.

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