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Wall Street: where midgets are giants

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March 24, 2011 – Comments (13)

I shall endeavor, in these last minutes of my day, to offer why I honestly think that individual investors have a big advantage over big-money in this game.  I honestly mean that.  There are so many reasons.  But before I get into that, I just want to acknowledge that probably almost all of the things small investors complain about with respect to wall street are true, and more.  We do have some significant disadvantages here, without a doubt.  Its just that our advantages outweigh those and much more.  

Look, big money has alot going for it.  They get a chance to buy every IPO, to buy behind-the-scenes semi-IPOs like Facebooks recent deal, they get to buy under the market secondaries, and they get a chance to other stuff we simply can't, and more.  You and I don't get to do these things.

They get inside information.  If you don't think that happens, and if you think that Raj Razajajasmartaparian was the only guy who got it, you're smoking really good drugs.   They all get it, be serious.  I bet it happens so often that its just a part of life.  Me?  I've  had a hard time several times just getting investor relations on the phone, or to reply to an email.  When they answer, they often just tell me to go read the 10Q.  

They have research staff, and this is their job.  We often have jobs, we have families, friends, hobbies, pubs to go to, and when we do those things nothing is getting done about our investments.  They can tell people to sit and read a 10Q and report on X, Y, and Q in the morning. 

We get screwed all the time by the machines.  Probably every trade we make we lose a couple cents per share or something to somebodies program somewhere.  They can front run stocks, have their own analysts help them buy or unload positions, all of that and much more.  They almost certainly hire people to scare people and stuff, via message boards, blogs and all of that.  

And more.  This wasn't meant to be a tome or even a competent commentary on the advantages that big money has, it was just meant to acknowledge that they have some really big ones.  You can insert wild zero hedge conspiracy theories or whatever you want, some of it is true at a minimum.  

But we still have the advantage, in so many ways.  Lets make a list:

1.  Less pressure:  We don't have to perform every month and quarter.  Think about this one:  imagine you have 2 strategies, all plotted out and calculated, upon which you started hedge funds.  One returns say 30% per year but drops 2x as much as the market when the market gets ugly.  So you're down 15% in the recent downturn, 30-40% last summer.  The other returns 20% per year, but at worst loses a few percent some months.  Clients of your first fund call during a scary time, like last May, and ask how you're doing, you say "down 40%, but don't worry we're going to make 30% this year".  The clients of your second fund call last May and you say "well we're up 1% this month, and 13% on the year, but we don't think that pace will continue and we'll probalby make 20% this year".  

Which fund attracts more capital?  The second, by 50 times.  Pros are under huge performance to not perform over the 18 years of your kid's childhood, not over the 30 years you make enough to save and invest before hopefully retiring, not over a couple of  years to keep your spirits up, but over every single quarter if not month.  

This is a significant advantage that allows us far greater flexibility in strategy.

2.  Less pressure:  Pros can be under pressure to not be long the "wrong names".  They can be under pressure to be long whatever went up most in the last quarter, so as to look smart in their SEC filings.  I have read people talk about this many, many times.  

You can own whatever you wish, whenever you wish, you are under pressure to nobody to "look smart".

3.  Less pressure:  You don't have any pressure to follow analysts.   Peter Lynch once quipped that "nobody ever lost his job for losing his clients money in IBM", meaning that if you're running a big mutual fund and buy some stock thats out of favor, you may not be able to explain why you lost all that money if it fails, but if you buy something "approved by the system", you can wash your hands of your failures.

4.  Less pressure:  you can accept more volatility in your portfolio.  This is more ro less a repeat of #1 above, but its so important.   More on this later.  

5.  You are more liquid:  you can buy small cap stocks, even microcap stocks.  Most of the priveledged big money almost literally can't put any meaningful amount of money into small cap stocks.  If you're running $5 billion, honestly, you are somewhat limited.  You take a meaningful position in a company with a $300 million market cap or even $1 billion market cap, and you literally have to buy 10% of it AT LEAST for it to matter at all.  And in buying that many shares, and subsequently selling that many shares, you run the price up, and then run it down.  You're intrinsically penalized in this way immediately and possibly quite significantly if you are big.  We're small.  

Here's a list of stocks that were honestly just too small in market cap for big money to even be able to really mess with in early March, 2009, just some that come to mind:  ASH, ACAS, ALD, MCGC, ARCC, BZ, JOEZ, NCX (its gone, it got bought out at a 300% premium to its price in Feb 2009), HUN, Chemtura, CENX, ATPG, and HUNDREDS more than went up many many times.  In fact the great majority of stocks that really roared since those bottoms were simply too small at those bottoms for big money to be able to significantly bother with.  Even LVS, HIG, XL, and more were really too small.

We could have piled huge money into CNO, into those ridiculous 50-bagging car rental stocks, whatever.  Whatever.  

6.  You are more liquid:  you can hedge better than they can, far more easily.   You can do some incredible things that big money can't even think about.  Here are some examples:

You can go buy some ASH, say 1000 shares, because you think its going to $300 this year, and then you can buy puts to cover it.  10 contracts could be traded in 3 seconds and you could probably split the bid/ask spread nicely.  If you had 100,000 shares, you're sunk.  No way you move 1000 put contracts to hedge your bet without murdering yourself on the spread.  If you can get that many at all.  And you may prompt a marmket maker to short your stock to hedge itself against its short puts, causing yourslef some side-misery.  

We can sell calls on FAZ, using the proceeds to pay for puts on XLF.  Make the decay intrinsic to FAZ work for us, nowhere near enough liquidity in FAZ calls to even somewhat make that feasible if you're running even a couple hundred million.  

You just have more options.  to list them would take pages and a week to type.  Its my favorite discussion and topic in the market:  bizzare uses of all of these fantastic toys they've given us to play with.  The pro's can't play with most of them.  

7.  You ar emore liquid:  you can use the options in almost any stock.   Forget hedging with options, you can actually USE them.  There are literally just a few dozen stocks with enough options liquidity to allow large amounts of money to be moved in them.  A small investor can use the options in anything.  

8.  You are more liquid:  you can make strange trades big money simply can't.   Forget small caps, and forget options.  You can do really smart (>>>>in my view, proceed at your own risk and after thinkingit over yourself, and after a great deal of calculation and spreadsheet making, do not listen to me, I am an idiot and will lose all of my money anyday now, really, never listen to me<<<<) things like, every time the VIX spikes over 30 take 10% of your available margin and short VXX.  If it goes over 40, make it 20% of your available margin.   The VIX must mean revert, it is an absolute law of nature.  VXX will fall from those spikes in the VIX, period.  It can go against you, maybe dramatically, but if you simply take this step you will probably honestly add 5 or 10% a year to your returns.  Multiply that over a lifetime and the effect is epic.  Ditto FAZ (but thats a different sort of animal in alot of ways) or TZA or all of these other broken ETFs that should be shot.  Its free money, but there isn't very much of it avaialble, and the pros won't bother with it because it'd never make any difference to them anyway.  But it can put your kids through college and buy you a new corvette.  Even having what is still a tiny amount of money compared to any notable hedgie to run and I run smack into limits trying to pull these stunts.  My brokerage tells me it has no more shares to short, I try to put some puts on VXX and the market just won't take my order.  No way anybody with a ton of money to run even looks here.  You should, except not because I said so because as disclaimed above I am an idiot.  

Also, this can be an incredibly spine tingling experience.  It is not for the feint of heart, or anybody who can't deal with waking up one day and having their portfolio down ALOT.  Do not do this casually or recklessly, do not do it on such a scale that if things really blow up it destroys you, don't be greedy with it, just treat it as a free, extremely low risk, 5 or 10% a year.   Did I ever tell you guys about the times my portfolio has been down double digits in a day?  rotflmaololololol.  I am not always as conservative as I seem.  See #1 and #4 above, if you were under their kind of performance pressure, this would be a HORRIBLE idea for you to try.  

But we're not, because we are nobody, and that gives us a huge advantage. 

All these marvelous, marvelous toys.  

9.  You can simply make them work for you, for free.   Read their 13Fs.  They have to tell you what they are in, and they usually tell you why.  Make their research team your research team.

Remember when Bill Ackman (who is an incredibly impressive guy when speaking, by the way) was buying up GGP with a big theory on it?  And Bruce Berkowitz was right there, so was Whitney Tilson?  Yeah they told you they were doing it, and why, when it was like 55 cents.  

I never read a GGP 10Q, I never read a GGP message board, I never read their financials, nothing.  And I got my only 40 bagger to date because I just figured "ahh screw it, if all these guys are into it I'll throw a percent in there and see what happens".  

Make them work for you.  Now you, sort of, have a reserach department hard at work while you're at the movies with your family.  

10.   You can actually be a contrarian, they ARE the crowd.  No further comment

Beyond that, read this book.  Then read it again, its just awesome.   

At the end of the day, plain and simple, these advantages easily outweigh the advantages that the pros have.  BY ALOT.  If you have $10k in an account, you're better off from a potential return perspective than if you have $100k.  

All these marvelous toys. 

13 Comments – Post Your Own

#1) On March 24, 2011 at 4:07 AM, TMFBabo (100.00) wrote:

Love the post and loved the Dreman book. I completely agree on individuals having a huge edge if they're willing to become reasonably skilled investors. I'll add:

The average retail lemming is a moron and buys high and sells low - look at fund flows.  Mutual funds (and many hedge funds) are severely crippled during market crashes by having to sell undervalued stocks because retail investors are leaving en masse.  They're also forced to buy overvalued stocks at the tail ends of bubbles when retail investors are finally piling in completely. 

My point is debunked completely if someone can point out that closed-end funds don't outperform mutual funds, but still.  

Mini-rant on Wall St. and analyst ratings: analysts get a lot of flak for giving sell ratings, since that prevents the firms from doing profitable investment banking business (debt/equity offerings, M&A, whatever) with them.  Companies are only covered if they'll generate money for the analysts' firms. 

I don't think every analyst is dumb (they're not) - they just can't put sell ratings on stocks or they'll be fired or something else bad.  The whole system is just completely screwed up.

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#2) On March 24, 2011 at 4:35 AM, checklist34 (99.69) wrote:

Babo, thats a terrific point about mutual funds.  They are literally hand-tied when they get really big. 

And thats a good point about "willing to become reaosnably skilled investors".  But I think in general the CAPs game has quite a few people willing and able, so its a good place to put it up.

And yes, analyst rankings are ... treacherous.  

Thanks for the points, I wish I'd have thought of the hand-tied nature of mutual funds, that should have been #1.

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#3) On March 24, 2011 at 7:20 AM, JakilaTheHun (99.93) wrote:

Great post, checklist.  I agree that individual investors have many advantages that are ignored. 

I would disagree on one level:  Sarbanes-Oxley and a few other regulatory measures have pushed more and more companies into the private sphere.  It's great for private equity, but it's bad for individual investors. We're basically deprived of a lot of opportunities simply due to the fact that many companies will never go public, because of the significant costs associated with it.

Otherwise, I agree.  When it comes to publicly traded companies, in many ways, individual investors are at an advantage. 

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#4) On March 24, 2011 at 9:18 AM, Valyooo (99.36) wrote:

Great post, but I would like to ask if anybody knows, are hedge funds victims of the same pressures as other mutual funds / financial analysts?  Generally hedge funds have less clients, and those clients have a lot more money (and I would assume tend to be smarter).   Mutual funds and other financal advisors obviously have to buy high sell low sometimes, but hedge funds too?

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#5) On March 24, 2011 at 9:28 AM, checklist34 (99.69) wrote:

thanks Jakila.  ... if more companies are desiring to stay private, that would hurt individual investors more than big funds because companies tend to come public as small caps?  More companies would stay private, if possible, longer?  I think I get what you're saying there.

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#6) On March 24, 2011 at 9:35 AM, checklist34 (99.69) wrote:

Valy,

    It was the hedgies I was thinking of.  A mutual fund winds up so tied to the market, they can just say "well put more money in from your 401k, dollar cost average"

    Its the "smart money" hedge fund guys that are under more pressure, I think.

    Hedge funds probably suffer less from the moving-the-market-getting-in-and-out stuff, and don't ever have to buy, but several stocks in the last couple of years have become "hedge fund hotels", so to speak.  Extremely popular with hedgies and so they drop fairly dramatically when the hedge fund community "de risks".  PFE last summer, I think alot of the strange share price action in BAC is a result of it being so wildly popular with hedge funds over most of mid 2009 to early 2010.  

    And if you read many hedge guys stuff, sometimes a surprising number of them wind up with the same ideas at the same times, possibly from hired outside research firms or some such mechanism.  

    It would be, of course, possible to have a truly independent hedge fund, even a big one.

    I think alot of the behavior of financial shares over the last 1/5 years is related to the hedge fund/mutual fund differences.  Hedgies bought up financials en masse, in fact many of the biggest ones were really concentrated in financials for over a year now (Apaloosa, Paulson, more).  But I don't think the mutual fund world has fallen back in love with financials yet.  So I think hedge money drove the dramatic ramp from March 09 to Septemberish 09, and the next big move off the gigantic plateau financials have sort of found themselves in since will have to be driven by the reall, really big money - mutual funds - whenever they get excited about them again.  Just a thought.

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#7) On March 24, 2011 at 10:42 AM, Option1307 (29.72) wrote:

I'll throw another advantage into the mix.

One of the most successful strategies for me has always been to buy into value plays and "sit and wait", frequently doubling down if need be. This is something that many funds can't/won't do.

Try telling your clients,"hey this will be sweet in 2-5 yrs., you just need to wait, promise..." Or having to tell your clients you are down 40% and are going to double down, ha, not going to happen in most settings. This definitely relates to fund managers having to "show" quarterly results and not taking strange positions as you mentioned above. However, often times those are my favorite stratagies.

I've never been one to mess around with shorting the broken funds, but that does seem like a very viable straegy and I completely see your point that it is a sure advantage. Intriguing if nothing else.

For all of the disadvatages out that individual investors are faced with, and there are numerous ones as you mentioned, I think "we" as investors in general should be more optomistic and learn to take advantage of the situations we can.

+1!

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#8) On March 24, 2011 at 12:02 PM, checklist34 (99.69) wrote:

option,

     Thats a great point to add.   And you're right, your fund would be out of business in short order ifyour trades went against you but you said "just relax, in5 years this will work out".  

     And in addition to losing clients, you'd get mocked in public and on seeking alpha if you doubled down while you were down 40%.  "failing hedge fund manager option1307 doubles bad bets"

     For shorting the broken ETFs, a couple of notes need to be added maybe:

1.  First, these things have been more "broken" over the last 2 or 3 years than they will be in normal times.  It will be wrong to extrapolate the drop of VXX or FAZ from the last 2 years into the future.  There's alot of reasons for this including the fact that the VIX was like 60 when VXX was created so it had a 75% drop built into it from the beginning, and the extraordinary volatility of late 2008, early 2009, summer 2010, has contributed to what is probably an unusually large level of decay in FAZ/FAS/TZA/etc.  Third, contango has been extremely high in numerous futures curves, due to the extreme dislocations in the market last summer and in late 2008.  With lower contango likely in the future, one should assume lower levels of decay in contango-affected ETFs.

2.  small caps can trend one way for an extremely long time, so can financials, etc.  I have read threads in various places discussing the potential glories of shorting pairs of levered ETFs.  This should not ever be attempted lightly.  Because if something trends one way for a long time, you can blow yourself up trying this.  One needs to very carefully consider how you do it and very, very carefully (and intelligently) hedge extreme outcomes in both directions, and equally careful consideration needs to be paid to when to rebalance them.   

But just shorting pairs will be one of the riskier trades a person could make.   I had some beers and dinner once with a couple of hedge fund guys who weretalking about all the people that tried this when those things first came out.  Per them, a couple dozen funds were set up just to short sell the pairs of levered ETFs, like FAS/FAZ, just go short both of them. 

These guys said that every one of the funds had blown up in the summer of 2009, within months of opening.  See two things happened, A) the volatility in the markets dropped dramatically, greatly reducing the rate of decay and B) the markets went up, alot, for a long time in a row.  That caused huge destruction for anybody short the pair in anything even close to similar amounts in early 2009.  

Game over.  This is an extremely interesting possibility, but it is just not nearly as simple or "sure" as some blogs I've seen make it out to be.  

3.  Its the VXX short on VIX spikes that is the best play, that anybody could do an suceed at.  Don't do it big, because VXX can blow up at an incredibly fast rate, and what you don't see on the VXX chart is what would have happened in the fall of 2008.  I've guestimated/gestticalculated it.  The enormous spike in the VIX (4x) would have been one thing, but the enormous backwardation that no doubt existed when the spot VIX was at 80 is what would have killed you.  It would have anti-decayed at an incredible rate and blown everybody trying it to bits.  Causing extreme sorrow and accelerated sales of cheap whiskey in Manhattan.

So, short it with a fraction of your available margin when it spikes above 30, double down (and you would be down, way down) if it clears 40.  And then the beauty becomes the fact that the VIX must eventually go lower, that is cast in stone absolute, the VIX will not remain above 30 or 40 forever, so combine that with VXX's propensity to decay and you will eventually win.  

The way you'd lose is if they shut it down during a big spike.  Which would suck.  Shoot for 5-10% extra per year.  Which will change your life in 10 or 20 years.  Do not do anything so rash as to risk a margin call. 

4.  Also, whenever one is looking at alot of different things, it can really help to take the tendency of these things to decay into consideration. 

You want to hedge against a down-draft in small caps?  You could buy TZA or calls on TZA, which would go up if they went down, but then the decay is working against you.  Instead, considering shorting TNA or, safer, buying puts on TNA.

Now the decay is working for you.  

That decay gives you a 10 or 20 percent a year margin of error.  Which is a whole lot if you think about it...

But the market doesn't price that decay into the options chains at all, not one bit, which can make using options to place bets on these things attractive.  A case where somebodies black scholes computer calculator thingie is easily outsmarted by a dude on a sofa with an aging laptop. 

5.  Messing around with tehse leveraged and "broken" ETFs can and almost certainly will add volatility to your returns.  Maybe alot of it.  I'd post up 10 pages of thoughts on how to use them, and then hedge against the use of them, but that would be so dry and boring that it would probably cause people to vomit on their keyboards.  

 

I agree sooooooo completely with this:

I think "we" as investors in general should be more optomistic and learn to take advantage of the situations we can.

We have more opportunities, and more things we can trade, and more of these "marvelous toys" we can play with than the big guys.  We can make this work for us.  

 

Disclaimer:  All of these opinions and ideas for augmentations to ones normal strategy are mine, and the product of an insane person.  I should not be listened to under any circumstance, and you should not make these trades.  

 

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#9) On March 24, 2011 at 12:08 PM, checklist34 (99.69) wrote:

the biggest risk to messing around with those levered ETFs from the short side is panic.  they can go against you so dramatically, so quickly, and you have to be 120% sure you can sit down and say

"ok, I know for a fact my studies and calculations are right, I know for a fact I'll win on this in the end.  Its just a paper loss, I can take it"

But that won't stop the impact it can have on your psychology.  

I keep a pacifier, a baby blanket, a bottle full of chocolate milk, some squishy toys and a teddy bear under my pool table, and sometimes jsut spend a day or 2 at a time laying there in the fetal position consoling myself.  

Everybody copes with stress their own way, thats how I handle it. :P

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#10) On March 24, 2011 at 4:40 PM, L0RDZ (83.13) wrote:

Can we just please just get some tater tops.

 

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#11) On March 24, 2011 at 5:59 PM, awallejr (85.45) wrote:

Have to say Checklist some of your recent blogs were a bit wacky from my viewpoint, but this one is one of the main reasons I visit this site, to get investment ideas and, hopefully give useful ideas.

One of the things an individual needs to assess first is what kind of risk can they handle?  And that will probably guide one's action more than anything.  Some can't handle wild swings, in which case buying defensive, solid stocks paying dividends with low betas might be what they should do (and writing calls to gain extra income off the longs).

Others can handle the wild gyrations in which case they should look for higher beta stocks.

But in either case, I personally think one should always devote some "gambling money" on speculative plays.  You have to be comfortable to lose it all (so it shouldn't be a large part of your holdings).

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#12) On March 24, 2011 at 10:51 PM, rebello15 (< 20) wrote:

amazing blog, wonderful insights

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#13) On March 27, 2011 at 9:01 PM, Frankydontfailme (27.27) wrote:

"I keep a pacifier, a baby blanket, a bottle full of chocolate milk, some squishy toys and a teddy bear under my pool table, and sometimes jsut spend a day or 2 at a time laying there in the fetal position consoling myself. " ( checklist34)

 

Funniest thing I've read in a month... 

  

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