Who is on the other side of the trade?

In every stock trade there is a buyer and a seller. Outside of those trades motivated by tax planning, overall portfolio issues (e.g., meeting margin calls), and other reasons not related to the stock being traded, either the buyer or the seller will have turned out to make a better choice. Every gain comes at the expense of someone who misses out on the gain. On average, everyone earns the market return (unless they short, in which case they lose the market return). But beating the market (which is what every stockpicker aims for) is a zero-sum game.

Chess and fisticuffs are other examples of zero sum games. In both cases, the market return (or, more accurately, the expected return) is zero. The average chess player will win half the time and lose half the time. Imagine that you are playing a chess tourney for big money. Further, imagine that you have no clue whether you will face Gary Kasparov or a guy who learned to play a week ago. Would you expect to win the tourney or even to do well? No, because you will likely run up against some very talented players quickly. If you do well, it will be due to luck alone.

The stock market (and other financial markets) are like this chess tournament. You have no clue who you are up against, but it is likely that you will face very skilled opponents. Think about who might be selling when you are buying, such as a hedge fund manager or short seller or company executive. If that scares you, perhaps you should be in index funds. If that doesn’t scare you, it still makes sense to be invested in index funds.

I learned this the hard way a year ago. Now, most of my money is in index funds.

Meeting the woman who sold me my stock

About a year ago I wrote a recommendation of Building Materials Holding Co. [[blg]] for my investment club. The report found its way into the hands of a hedge fund manager who was shorting the stock. Eight months later, when we met, she showed me my report with her notes made eight months earlier. She had noted that the company should be selling for 40% less than its price then of $24. It had fallen to $13, exactly her target price. It is now 50% lower than that price. Needless to say, she was smarter than I was from day one and she turned out to be right.

Generally, it pays not to be on the other side of the trade from someone who is very smart. So if insiders are buying, it is generally profitable to invest with them. If they are selling a lot, it is generally a good idea to follow their lead. Buying alongside activist hedge-fund managers can also be profitable, though less so than following the move of company executives.

Knowing who is on the other side of the trade is one of the reason I like short selling penny stocks. I can usually be confident that the buyer of the stock I sell is naive and greedy. Those two characteristics do not make for smart investing.

Disclosure: I thankfully no longer own BLG.

Leave a Reply

Your email address will not be published.

Please complete the formula below to prove that you are human * Time limit is exhausted. Please reload CAPTCHA.

This site uses Akismet to reduce spam. Learn how your comment data is processed.