Anand Iyer, after reading the article I wrote in Wired with Jon Stokes, emails with a couple of questions:
The age of analysing a company’s stats, looking at its balance sheets, researching the market the company operates in, and looking at the people running the company seems to be gone. It’s all bots (highly sophisticated ones) who operate the financial world.
What I wanted to ask was would it make sense for a single person to be doing investing the good old fashioned way in this scenario (I do and I guess I will even if your answer tends to suggest in the negative, but I would be VERY interested in your answer).
Finally it would be very helpful if you were to recommend me some books on this algorithmic approach of investing and advise if it is indeed possible for one individual to do the very same thing.
My answer, I fear, won’t make Mr Iyer very happy.
Firstly, there are millions of individual investors doing diligent homework on companies and trying to invest intelligently in the stock market. When they finally arrive at a conclusion and the time comes to buy or sell, their collective decisions are known politely as “retail order flow,” and less politely as “dumb money”; high-frequency trading shops make lots of money by paying for the privilege of filling those orders and taking the opposite side of those trades.
It’s possible that one individual investor"”Mr Iyer himself, perhaps"”can beat the odds and make more money on his own than he would do simply investing in an index fund. If he does, then it might be due to luck, and it might be due to skill. But if I know nothing about Mr Iyer except for the fact that he’s a retail investor looking at corporate fundamentals, I wouldn’t give him much of a chance of beating the market. Fundamentals-based investing is (still) a very crowded trade, and most people who try it fail"”they get picked off by faster, smarter, more sophisticated players in the market.
On the other hand, fundamentals-based investing is vastly more sensible than an individual investor even thinking about entering the shark-infested waters of high-frequency algorithmic trading. You can’t do it, don’t even try. If you do give it a go with real money, expect to lose all that money, very quickly.
The good news is that for the time being it’s not even possible for individual investors to enter this market: the barriers to entry are just too high. But if it ever does become possible, stay very far away. Unless you want to know what it feels like to lose years worth of savings in a matter of hours.
To first order markets are efficient, so to second order you want to focus on differences between you and the marginal investor. A lot of the smart money is institutionally impatient; if you can find an investment with solid fundamentals, you can perhaps wait for 5 or 10 years for it to make money, while the smart money may need to see something to trigger its performance in the short run. The large caps are much more heavily followed than small caps; you might have knowledge about a local chain with a $100M market cap that nobody in New York does. Additionally, your risk tolerance may differ from the average investor; if you’re less risk-averse — be honest — then it might make sense for you to be in riskier securities. If you’re more risk-averse than most investors, know that, too. You are naturally more exposed to risk in the sector that provides your day job; don’t put all your savings in that sector as well. (This, unfortunately, tends to be a source of tension between your risk appetite and your information advantage.)
The high-frequency traders are mostly in the larger cap stocks, where they provide liquidity to traders who trade at somewhat lower frequencies. Unfortunately, they won’t be around lowering your liquidity costs in the smaller cap stocks. You will have to pay more for liquidity than you otherwise would, but if you’re only buying and selling every 5 to 10 years, it won’t be a big portion of your earnings. You’re far more likely to do well than if you chase over-followed stocks that have tighter spreads.
Finally, with any stock you buy, make sure you understand why everyone else hasn’t bought first. The stocks where I’ve made the biggest returns have been ones where there was an obvious cloud hanging over the company that I decided was less important than everyone else seemed to think. (In none of those cases did I put all of my savings into the stock. You’re not so much smarter than everyone else that you can never be wrong when you’re buying and they aren’t.) I’ve also been saved from buying stocks that looked very attractive until I figured out why other people weren’t buying.
The point about staying away from high-frequency trading is absolutely correct, with no qualifications. It may be possible to make money as a retail investor providing liquidity on a day-to-day basis, but even there you’re up against computers with better information than you have. Anything higher frequency than that is completely hopeless.
I politely disagree with Felix on this.
First, dWj brings up an excellent point — there are some stocks that are fundamentally less risky than others. If you can match your risk tolerance appropriately to the stocks you select, then you might be quite happy with a portfolio that lags a bull market.
Second, the “millions of individual investors” collectively manage less money than a single major brokerage like Fidelity Investments. It isn’t the numbers that matter so much as the financial weight they collectively carry. Most of the capital in the stock market is “institutional investment”, and while they have a small interest in beating the market they have a greater interest in keeping their clients — and in most cases that means not seriously underperforming the market. Most large mutual funds are reluctant to diverge significantly from their index. Which makes one wonder why they charging fees that eat up a significant fraction of the expected returns.
Third, it has been amply proven that the BIGGEST risk that an individual investor faces is the temptation to cash out of the market after it plummets and wait until it has gone back up again to buy back in. It is much easier to “stay the course” if you can point to every one of your investments, have confidence that they are profitable, will pay their dividend this year, and best of all that they will be even more profitable in ten years. Felix has stated several times that he has no confidence in the “market index”, and why should he? In contrast, I was adding to my stock holdings during the fourth quarter of 2008 and first quarter of 2009 BECAUSE I KNEW WHAT I WAS BUYING HAD VALUE.
As an individual investor, I pay a “tax” to the HFT traders every time I make a trade. The tax is almost certainly smaller than the $8 commission I pay to the brokerage, however, so I’m not going to sweat it too seriously. I don’t trade often enough for this to be a problem. The greater tax is paid by the institutional investors who submit large orders that the HFT can “front run”. They trade more often than I do anyhow.
One final point that dWj makes that deserves to be emphasized. You’re not smarter than everyone else. If a stock is beaten down, it is because there is a real risk associated. If you are in a position to accept that risk, you can profit handsomely (most of the time). If not, then the risk-profit goes to someone else. Either way, don’t bet the farm and don’t overstep your risk tolerance.
Hi Felix,
I have an article in an Indian newspaper, Business Standard, on the regulation of exchanges. Its a raging debate here. Would love you have your thoughts. I titled it: This Marketplace is a Monopoly. Thanks,
http://www.business-standard.com/india/n ews/vivek-oberoi-this-marketplace-ismono poly/421119/
TFF, I would add that a significant portion of institutional money is actually retail money that has been hoovered up in funds or pensions.
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