Leveraging Our Strengths and Outsmarting the Giants
Understanding Our Strengths and Weaknesses in Trading or Investing
To succeed in trading, it's essential to know where our strengths are and where our weaknesses fail us. We also need to be aware of inefficiencies in the market that only an individual can exploit.
The Smart Players: Their Advantages and Limitations
First, it’s important to identify who the smart players are. These are the big firms and hedge funds who have a lot of resources at their disposal. They’re trying to exploit market inefficiencies and to take money from less informed or less equipped market participants. Lets first discuss where we fall short and where they have an advantage.
Where the Little Guy Fall Short
Individual investors like us don’t have the same resource advantages.
We fall short on:
Time: We can’t dedicate full teams to follow industries or companies.
Coordination: We don’t have large teams to analyze every little detail.
Information: Analysts in big firms have more tools and access to information.
Hardware: Without high-frequency trading systems, we can’t compete on speed.
Because of these limitations we cannot compete on the informational side nor can we compete on the lower time frame. Anytime we feel like we know some type of unknown information, there are probably some unknown risk associated with it that are not being accounted for. We must look at where the big firms cannot compete or will not compete.
The Disadvantages of Big Firms
But where do big firms struggle? They have their own set of limitations:
Allocation Restrictions: They have to stick to their investment mandate. For instance, a tech fund has to stay invested in tech, even if the sector is performing poorly. Some mandates also do not allow them to go fully into cash as a position.
Volatility Restrictions: If their portfolio is too volatile, investors may start pulling out their money even if the firm is still profitable. If they underperform their benchmark, they will also see redemptions. On the flip side, they may receive capital contributions at times when they don’t want to be allocating, especially after a recent period of overperformance, which is often followed by underperformance.
Liquidity Restrictions: Large funds have to deal with liquidity issues. They can’t quickly get in and out of stocks because their sheer size moves the market, making it harder to buy or sell at a good price. They also have to spread their investments over a huge number of stocks just to manage liquidity. This over-diversification can hurt their returns as they are diversifying into lower quality stocks.
Our Edge to Exploit
So, what’s our advantage?
Capital Size: We’re small enough to be nimble. We can get in and out of positions quickly without moving the market.
Concentration: We can afford to concentrate our investments more and avoid over-diversifying into less attractive stocks just for liquidity’s sake.
Flexibility: We aren’t tied to any sector or investment style. We can go to cash when things look bad and re-enter the market when conditions improve.
Speed: While we can’t compete with the speed of high-frequency traders, we can move faster than the big funds. We can ride their coattails when they’re building a position, and if things go south, we can exit with minimal losses before they fully unwind their positions.
Volatility: We can take on more risk in pursuit of high risk-adjusted returns, without worrying about investors pulling capital based on past performance.
Playing to Our Strengths
With our smaller capital size we can focus on strategies with lower liquidity such as focusing on smaller capitalizations or new frontier markets. We can also leverage our speed to look for buying and selling foot prints in the price action of larger capitalization stocks. We can also look for profitable strategies that have some type of flaw that makes they unappealing but have very good risk adjusted returns. Such as strategies that are not very consistent, too volatile, or very infrequent trades. We also have the ability to sit in cash and change around to different markets depending on what sector is doing well.
