Algorithms vs retail investors

By Felix Salmon
January 10, 2011
article I wrote in Wired with Jon Stokes, emails with a couple of questions:

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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.

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Comments
19 comments so far

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.

Posted by dWj | Report as abusive

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.

Posted by TFF | Report as abusive

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/

Posted by bandraboy | Report as abusive

TFF, I would add that a significant portion of institutional money is actually retail money that has been hoovered up in funds or pensions.

Posted by Danny_Black | Report as abusive

Is there any truth to the “first of the month” strategy, that the first day of every month largely accounts for the gains during an entire year? Is this due to the big money re-balancing their portfolios at the start of every month?

If so, I think it’s wise to realize the constraints that the big money have placed on them that retail investors do not and take advantage of that IE not having to worry about redemptions or fixed periods of re-allocation.

Posted by djiddish98 | Report as abusive

As someone who makes his living investing other peoples money in individual stocks I can tell you that there really is no right or wrong between the indexing approach or individual approach.

TFF and DWJ are both right when they say that “smart retail” can beat the market like a drum over time.

If you ask me the truely dumb “retail order flow” comes not from people who are logging into e-trade to sell their 100 shares of JNJ, KO, & IBM at the worst possible moment… but from the people who are calling their brokers assitant to dump their XYZ Agressive Growth funds in the middle of a market panic. That’s why I will always prefer individually held stocks to funds.

The people who listened to Cramer say “GET OUT OF THE MARKET IF YOU NEED THE MONEY IN THE NEXT 5 YEARS” on 10/6/2008 and never returned (or who are just returning now.) – There’s your dumb money. Timing wise Cramer was right… from October 6th 2008 to the March 2009 low the market dropped a little over 30%. To the extent you avoided that bloodbath good for you. Yet from 10/8/08-today the market is UP almost 30%… so I hope the people who GOT OUT remembered to GET BACK IN.

I’d bet that most people who regularly read Felix’s blog could beat the market over their investing lives so long as they can promise never to bail out when the market is dropping like a rock. There are a hundred great investing quotes out there but my favorate is “the best time to buy is when there is blood flowing in the street and some of it’s yours.”

Posted by y2kurtus | Report as abusive

Felix, wouldn’t you agree that arbitrage is now in the same category of algorithms? Detecting price inefficiencies in multiple markets has to be owned by Renaissance and Shaw at this point, no? Are there opportunities in arbitrage today for retail investors?

Posted by esclyme | Report as abusive

“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”

Check; but what now? Very, very few bargains around, and the ones I got in 08-09 are at [or past] the fully valued stage. Lovely companies, solid management, usually at least some moat, all slowly regressing towards the mean. At the same time, I will never see those companies at those prices again.

Still, for the time being, though my money be dumb, it seems like there’s a whole lot of smart institutional money that would like to take its place.

Posted by ARJTurgot2 | Report as abusive

ARJTurgot2, my personal focus at this point is highly risk-averse. If I can achieve 3% real returns over the next 20 years then I’m set for life — and that is a target that I believe I can achieve without straying far from the most boring defensive stocks on the slate.

Ideally I would love to be getting part of that return from bonds, but with yields in the toilet that isn’t an option right now. So I have been funneling new money into mortgage repayment and carrying 80%+ of investment assets in companies that I am certain will be worth more in 2020 than they are today (while paying a 3% dividend yield throughout). Can’t think of any better strategy to meet my goals.

Not sure where I would look for growth right now. y2kurtus has a good strategy, but you have to implement it very carefully.

Posted by TFF | Report as abusive

@TFF

Greed never rests. I’m evidently older, my urchins are through grad school, we held on to the mortgage docs for historical purposes, and the annuity is somewhat inflation adjusted. I owe on a library fine, but on consumer debt we’re part of the vile class exploiting the poor; forget miles, my credit cards pay me money.

But, my lessons in life lead me to the conclusion that there is a dearth of competence in many of our leaders and leading institutions. Sadly, my time in government exposed me to some of our state and national leaders. Not encouraging. In those circumstances I think you have to stay in growth mode. The urgency drops, and you can be selective, but you have to stay in the game.

Posted by ARJTurgot2 | Report as abusive

ARJTurgot, it sounds like our situations are not too different (though you are likely 20 years older). As you say, you can never abandon equities in a world where inflation remains such a risk. My hope is to construct a retirement portfolio that provides for my income needs through dividends, keeping a modest allocation in cash and perhaps bonds for liquidity. Not terribly different from my present strategy.

Our top four holdings right now (in order from least risky to greatest return) are PG, JNJ, ABT, and IBM. Pharma is facing a tough decade, however the wiser companies are using the present cash flow to invest in other businesses. I expect they will maintain their strong dividends while achieving slow growth. IBM is one of several very similar “mature tech” companies, providing essential services on a scale that smaller businesses can’t touch. Their growth prospects are likely limited at this point, but their margins and cash flow are strong.

Dividends, stable earnings, and P/E below 15 limit the downside risk in an economic downturn. All stand to benefit from global growth. I hesitate to place big bets on any single issue, but have a dozen holdings of this nature that form the core of my portfolio.

Posted by TFF | Report as abusive

One more observation? Taking on risk is most profitable in the midst of a panic. Everybody knows which stocks are likely to suffer most in a downturn, and they get dumped first (and hardest).

Consider a “counter-cyclic” philosophy? When the market projections are rosy, be content with high-dividend slow-growth stocks. Eventually the market will turn, and those will hold up better than their riskier peers. Then you are perfectly positioned to pick up some bargains.

Volatility is a long-term investor’s best friend.

Posted by TFF | Report as abusive

Felix fears volatility:
http://blogs.reuters.com/felix-salmon/20 10/05/10/why-volatility-means-you-should -sell-stocks/

Since May 10, the S&P500 is up 15.7%. It did fall first — so Felix did okay as long as he jumped back in before mid-September. Still not sure it makes sense to try timing the market like that.

Posted by TFF | Report as abusive

TFF, so you were a buyer of BSC and LEH during 2008?

(Tongue firmly in cheek…)

Posted by Danny_Black | Report as abusive

Very funny, Danny. :)

I actually was trading through some of the banks (BAC, WFC, WB) at various points during the slide. I’m potentially prone to “value trap” just like any other value investor, and I didn’t immediately recognize how serious the problems were.

Happily bailed on WB as soon as it became apparent that the CEO was lying through his teeth about the financial health. Got burned a bit on the shady BAC/Merrill deal, but profited nicely on WFC. Overall a wash — but could easily have been much worse.

Am sticking to more transparent businesses for now, thankyouverymuch!!!

Posted by TFF | Report as abusive

My most immediate problem is PetroBras. Today the PEG on it was north of 4. I bought it during the end-of-the-world sale at well less than a PEG of 1, have made buckets, so, time to boogy. BUT, PetroBras is already the Latin American Exxon, pays a dividend, will be a major partner with China, owns the South Atlantic, and can even get along with Chavez. Plus, if you think about commodities as holdings, oil would seem to be on the list. But, dayyam, 4? You could at least eat Tasty-creme donuts. And it is just one of my picks like that. Existential dilemma time.

Posted by ARJTurgot2 | Report as abusive

PEG is hardly a definitive measure, especially if relying on past history rather than future expectations. Sometimes it makes sense to evaluate a slow-growth company on its profitability and free cash flow.

If I recall correctly, they’ve been a bit capital-constrained. Partnerships with China would help that.

But I avoid because they are politically opaque.

Posted by TFF | Report as abusive

http://fragmentation.fidessa.com/wp-cont ent/uploads/High-Frequency-Trading-Optiv er-Position-Paper.pdf

This one correctly illustrates typical strategies employed by so-called high-frequency traders.

Posted by kosmik | Report as abusive

China already there:
http://pipelineandgasjournal.com/petrobr as-china-sign-10-billion-deal

Politics… it’s been fascinating watching the politics on this, and they may be opaque, but they are hugely covered. These is one of those cases where China is buying the assets of a continent. I did a foot-loose-retiree trip south in late ’09. In Buenos Aires you probably can’t go anywhere in the city and not see some form of PetroBras sign at least every 5 minutes; Soccer teams, bus stops, empanada stands, t-shirts on kids. And that’s in Argentina. In Brazil, it’s total.

Posted by ARJTurgot2 | Report as abusive
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