This article is for those of you who want to get more out of the effort you put into investing. Better returns; more consistent performance; a better grasp of how the game works. And most of all, this article is a cautionary tale about hubris.
The Dilemma
You know that you should be getting better and more consistent returns, but you’re not sure how to go about it or who you can turn to for help. You want useful information, honest advice, and expert guidance about what to do. You want confirmation that you are on the right track, and a reality check to find out if you’ve been doing some things wrong.
Your dilemma is that you don’t trust the financial advice industry to give you straight answers. Maybe you’ve had a bad experience or two with an adviser. Maybe you got badly burned by someone promoting a hot stock that cratered soon after you got in.
You also don’t trust the information coming from the financial media, and the numbers reported by the company itself. You know that earnings can be manipulated six ways to Sunday, but what can you do about it? What can you do to raise your investing skills to a level where you can be confident about the decisions you make? That’s what I want to explore.
Bloodsport
Investing is a full-contact, no-holds-barred competition between two types of investors: the smart money and the dumb money. (Don’t be offended by this, but the dumb money is mostly the retail crowd, which you are more than likely a part of. It’s not that you’re actually dumb, it’s just an expression that professionals use when they refer to retail investors. I’ll have more on this in a future article.)
For the smart money, trading against the dumb money is like shooting fish in a barrel. For the dumb money, it’s maddeningly complicated and frustrating. Professional traders dominate the market, and when the amateurs show up to trade, the pros are more than happy to take the other side. But I digress…
A bloodsport is an organized activity that involves aggression to the point where blood is being spilled. Dog fighting or boxing, for example. These events are staged for two reasons: entertainment and profit. Experienced promoters know how to combine both of these elements in a package that is hard for some people to resist.
Bloodsports are popular because they are a way for us to experience, vicariously, the brutal aggression that was an everyday thing for our ancestors. And the beauty part is that we don’t have to worry about our own blood being spilled.
In ancient Rome, watching gladiators getting mauled by lions and beaten by soldiers was considered mainstream entertainment. It was an unfair fight. The soldiers wore protective armor, and the gladiators wore loincloths. In the arena of modern investing, you are the gladiator.
There are dozens of stories in the Bible about fights to the death, where good triumphs over evil. David and Goliath comes to mind.
A predatory game
Economists call investing a zero-sum game. This means that for every winner (an investor who makes a profit) there must be a loser (who funds the profit of the winner). Since the stakes in the investing game are so high – i.e. your life savings– professionals will use any and all means necessary to gain an advantage over their less informed and lower skilled opponents. In this game, the professionals are the predators, and the amateurs are the prey. If you enter the arena of investing without sufficient knowledge, skills, and temperament – your odds of coming out a winner are only slightly better than a Roman gladiator.
A pay-to-play game
Money talks, and nowhere does it speak louder than on Wall Street. Those with the biggest accounts get the most attention, the best information, and access to the brightest minds available. The line that separates these information-haves from the have-nots is roughly $10 million dollars. If you’re lucky enough to have that much to invest, congratulations – you get to be the predator. For everyone else, it’s an uphill struggle. Here’s how the game works.
Buy Low and Sell High?
It sounds so simple, doesn’t it? Buy low and sell high. Simple, maybe. But not so easy. Amateur investors tend to hold on to their losing stocks for too long, hoping that someday they will get back to even. But in many cases the anxiety of watching their life savings go down the drain becomes too much. When they reach their breaking point, and they can’t take any more pain, they sell. That’s called Buy High and Sell Low.
Guess who’s on the other side of that trade? The pros understand that the stock market always comes back, eventually. They see opportunity when the amateurs start to bail out. They buy low and sell high.
The Good News
Here’s the good news. You don’t have to compete with the pros in order to win. That sounds dumb, I know. But I’ll explain what I mean and show you how you can beat most professionals (the smart money) at their own game, without even breaking a sweat.
Before you make another trade, ask yourself this question: what is my information advantage over the person taking the other side of my trade? What’s my edge? If you’re being honest with yourself, you will probably become more selective about the decisions you make. And that’s a good thing.
The Edge
You already know that the market is dominated by professional traders, so how can you possibly get an edge over someone with tons of capital, a team of Ivy League analysts crunching the numbers, and technology that would make the C.I.A jealous? What we have here is a David vs. Goliath situation. And that is the first clue about your potential edge.
The problem that Goliath had was a lack of speed and agility. He had the advantages of size, strength, and aggression but he was so big he couldn’t react as quickly as David. David used this to his advantage, and so can you. How?
The professional traders who dominate the market are like Goliath in the sense that they can’t react as quickly as you can. Why do I say that? Because I was a professional trader for more than 20 years, and that environment is fraught with office politics. These folks are dealing with huge positions – millions of shares – and they only have two modes: accumulate or liquidate. To make a decision about selling a big holding or building a large position in a new name, it takes a committee. And committees means meetings. And meetings involve office politics.
When I was head of trading at a large Midwestern bank, this decision-making process could take weeks. Under the best conditions, when I was co-manager of a hedge fund, it typically took several days to arrive at a consensus about what to do. This is what I call the Goliath problem. But you don’t have this problem, do you?
How to use your edge
Let’s be realistic. You’re not going to outsmart some of the smartest analysts on the planet. You’re not going to get a meeting with the senior management at Apple or Google or Amazon, so you can “read the room.” Your wallet is tiny by comparison, and your technology probably sucks. But here’s the deal. You don’t have to play in the same sandbox as the big guys. You can go mid-cap, small-cap, micro-cap, whatever you want. These guys can’t play in those markets because they’re too damn big, and the sellers run away and hide as soon as they show up.
Here are a few tips on what to do with your edge. These guys never over-pay for a stock unless somebody’s ego is involved. I’ve seen it happen often. So keep an eye on stocks that are currently out of favor, and keep an eye on the trading volume. You have to do your due diligence on fundamentals, of course, but you’re never going to know more than they do.
When you see a beaten-down stock start to rise, check the volume. If the volume is more than 2 or 3 times the average over the past 90 days, that’s a clue. But don’t jump in too quickly, because these guys like to pull back after their first go-round and wait for the price to come in a little. If you see another spike in price and volume, you have a green light.
Don’t get carried away
These David and Goliath situations don’t come along every day. You must be patient. Set up a watch list of companies where your own analysis says there’s some potential there. If you have a way to set up volume alerts, great. If not, it’s going to take you longer to play this edge. By the way, forget about those websites that claim to know what the big guys are up to. By the time the forms are filed, most of the trading is done.
There are a few other edges that go to the nimble trader, and I’ll address those in a future article.