So is it Game Theory?

Research
1

How does the smart money exploit retail investors biases?

If, for example, I think stocks with strong one-year momentum are good buys, how does the smart money take advantage of me?

Do they let me and other naive investors buy the stock inflating the price and then the smart money goes short?

Do they just buy stocks that have good eleven month momentum but have not yet shown good one-year momentum hoping I’ll buy (as they sell) in a month?

I’m guessing they do. What else do they do? How do they know which stock will be the best plays to exploit the retail investors? Is volume one metric? Is short money the smart money as Wes Gray says?

How long does it remain a good idea to buy stocks with good one-year momentum?

2

If you know that masses of people are buying or selling for a dumb reason, you might want to take the other side.

Dumb reasons list:
Seasonalities
Probabilities
Holiday effect
Charts
News
Biases
Bill Ackman
Pump & dump newsletters
Sell side fandom
Hype

Just to name a few.

3

primus - lets be clear that this is YOUR dumb reason list, not THE dumb reason list. I would be very hesitant to bet against seasonality or holiday effects. Charts and news would need to be much more specific to meet any dumb reason list.
Steve

4

Depends on who you refer to by “smart money”.
Professional traders who take the other side of the trade or retail banks?

One example might be to generate unnecessary anxiety.
Investment banks did spread one way of an argument in the past and have deliberatly taken the other (more promising) end of the bet on their books.
Retail banks encourage trading in either direction by providing up-to-date news and live prices and charts. Different specific trading options provide a sense of security when all they do is providing different options for the bank itself to hack the order books. And the banks are then screwed by other banks with a faster connection to the trading hubs.

If you substitute “how does smart money exploit retail investors biases” by “how do the rich keep an edge over the poor” I am not sure if such an edge exists. Many funds have failed in the past, as Tom has just laid out. I think retail investors can learn about the heuristics and biases as well as professional fund managers are equally prone to them. Not to say that experienced investors are especially prone to overconfidence. So one of the remaining edges remain in scaling your ideas - an option that is usually not available to retail investors.

It’s key to know the game and to know what games cannot be won on the level of an individual investor.

If you know the game and decide that you have the resources to play it, you can still chose which side you are on.

Best,
fips

5

One obvious way is by charging you fees. As Charles Ellis observed it is a “Loser’s Game” from the get go because of the commissions charged. Like the gold rushes of yore more reliable money was to be made from selling the shovels, pickaxes, and gold pans to gold miners than being a miner.

I could probably come up a few more novel ways based solely on my observation and intuition that you will probably not read about anywhere but for that same reason it would be valuable and not something to be freely given unless one wishes to devalue it.

6

Know your competitive Advantage. Small Investors do have huge Advantage over big Investors based on smaller size.
Beeing able to be out of all positions in a matter of days is a huge Advantage, also beeing able to invest in small caps!
Big Funds can not do this.

P123 is a huge competitive Advantage as well (I used to Need days to test a Thesis, here I Need minutes!).

On the other hand a small Investor would be in a very poor Position playing the day trading game against HFT Players, that win based on
high Speed connectivity, size and allgos that are better than the small Investor ones…

Just some examples…

Regards
Andreas

7

True dat. P123 lends us a huge leg up. Lots of investments theses out there. We are among few who have tools to test most of them out.

8

At the bottom of the recent correction I read about how “smart money” had already sold during the summer, and that dumb retail investors had been left holding the bag. Now the SP500 is above its September peak.

9

A lot of talk about ‘smart money’ is a myth. Who specifically is it? Name them in advance. Tell me (Forbes of whoever), who will outperform the market for the next 3 years.

I am invested in a long-short fund from QIM. They take directional bets on market direction. They have averaged 20%+ returns with a 1+ sharpe since inception in early 2008. I invested in Jan. 2009. Their largest DD before this year was 15% or so. They are clearly smart money on paper. They went short big in October of this year and lost 15% in 1 week.

However, I also invested in their Global Fund (redeemed this summer). They were named one of the best Global Macro traders in the world by many magazines in 2008 after 7 years of huge returns - including 2008. And had a 1+ Sharpe ratio. Since 2009 they have averaged about -2%/yr.

This same group launched then closed another fund (after it lost 15% or so in its first year).

LJM is one of the best long-term option traders around with a track record of 10 years or more. They lost 17% or so this past September in their most aggressive program and 12% in their basic program (they are still a very good fund, but down about 2% on the year). ( I am not invested).

Or look at the Barclay Hedge Fund index. These are the aggregate returns of all reporting funds in the Barclay’s index without (with a likely survivorship and reporting bias that inflates how well an investor would have done by 2-4% / yr). I have beaten this index by a lot on a risk adjusted basis since I started using P123. (Although some of my R2G’s haven’t since launch, unfortunately - and I feel bad about that).

See:
http://www.barclayhedge.com/research/indices/ghs/Hedge_Fund_Index.html

These funds tend to track around the same volatility and peak DD’s as a 60/40 portfolio. They have done about 2% this yr, but have underperformed the 60/40 portf. for a long time now. In fact, you have to reliably select top decile hedge fund managers to make money. This takes real time and the vetting of 100’s of managers by a skilled team. So, if all hedge funds are not ‘smart money’ who is?

Maybe Victor Niederhoffer. He averaged 35% / year over more than 20 years. And was voted the #1 Hedge fund manager in the world in 1996. Then he lost 100% of all his money (and his funds’ money) in 1998 or so. Then he clawed back and had amazing returns until 2007 or so. Then he lost 75% of his investor’s money and had his fund shut down. See:
http://en.wikipedia.org/wiki/Victor_Niederhoffer

He’s smart money. Right>

Or maybe it’s John Paulson. He pulled off the biggest most possible trades ever (at least top 5) in 2008 betting against subprime in a huge way - and had 2 decades of steady double digit returns with no losses prior to that. Since then he’s down huge, including 40% losses in 2011. This year he’s down 14% or so. See:
http://www.forbes.com/sites/nathanvardi/2014/10/09/hedge-fund-billionaire-john-paulsons-comeback-crashes-in-september/

So, people say smart money. And we can always find a handful of traders doing great. But, with the thousands of funds launching we can’t say if this is skill or luck. And many of the ‘best’ blow up or significantly underperform after cash inflows.

So, yes, if you are trying to compete against hi frequency traders, you are likely to lose. Judgetrade is right. But if you are buying and holding for 1-3 months at least - or competing in liquidity spaces they can’t - and you KNOW your advantage, you have a very good shot of outperforming hedge fund investors over long periods.

Or what about Warren Buffett? He did 35% plus returns early on over 3+ decades. But from roughly 1998 to 2013, you would have beaten him handily - over more than 15 years - by buying a value index fund - or equal weighted basket of small value stocks. See: http://www.marketwatch.com/story/warren-buffett-more-myth-than-legend-2013-07-03?page=2. He also has significant (very low cost) leverage that we previously didn’t get. Isn’t he smart money? He’s using no timing. But, he’s had a rough 15-20 years (I haven’t updated this - but did look at it at the beginning of last year).

‘Smart money’ is a tool of lazy reporters. They either just use the term when they don’t know who it is - or ‘annoint’ one or two people. However, most of these people then fail ‘out of sample’ if you track them long enough. Even for those who don’t it’s very hard to determine if it’s luck or skill. So many start the game, that even ‘random dart throwing monkeys’ - would show some winners after a decade. In fact, if we start with 10,000 managers and half make money annually by chance. 313 have made money every year after 5 years and 9 people after 10 years. Now, if they have some specific style and that style does well, the run can last longer. Or if people offer multiple programs and ETF’s and mutual funds, the same thing can happen.

A lot of hedge funds simple beat investors by charging 2/20 while investing their own money in ST T-bills (seriously), land and rental properties. They launch a lot of funds until something hit and then raise as much money as they can. R2G may or may not be different than that. Only time will tell. But, using P123 to find lots of different investments, controlling risk, knowing your advantages (and blending baskets of ideas) and holding down costs is something that can be profitable.

Try to find diversified return streams. The question becomes what do you (we) really believe in and can stick with for a decade. Chasing the latest ‘fad’ is a losing recipe. And why most retail investors significantly underperform buy and hold (by 3-5%/yr). The same will (likely) be true of unsystematic chasing of P123 strat’s.

Best,
Tom

10

Having gone on my long rant -

Smart money acts as market makers, not traders. They take advantage of making money on every trade. Or they rig the game. Or they charge high fees.

They then stay out of the markets with their own money (often).

11

I second Tomyani’s standpoint.
It’s easy (for the press) to identify smart money of the moment. Star investors make a good story for stellar short-term gains and are equally interesting to write about in case of extreme losses.

From a pure statistical view, there will always be outliers.
And true smart money in terms of consistent outperformance can usually only be identified in hindsight.

Buffett provides an excellent account on smart money in this sense, when he makes a case against the efficient market hypothesis:

“Before we begin this examination, I would like you to imagine a
national coin-flipping contest. Let’s assume we get 225 million
Americans up tomorrow morning and we ask them all to wager a
dollar. They go out in the morning at sunrise, and they all call the
flip of a coin. If they call correctly, they win a dollar from those who
called wrong. Each day the losers drop out, and on the subsequent
day the stakes build as all previous winnings are put on the line.
After ten flips on ten mornings, there will be approximately
220,000 people in the United States who have correctly called ten
flips in a row. They each will have won a little over $1,000.
Now this group will probably start getting a little puffed up
about this, human nature being what it is. They may try to be modest,
but at cocktail parties they will occasionally admit to attractive
members of the opposite sex what their technique is, and what
marvelous insights they bring to the field of flipping.
Assuming that the winners are getting the appropriate rewards
from the losers, in another ten days we will have 215 people who
have successfully called their coin flips 20 times in a row and who,
by this exercise, each have turned one dollar into a little over
$1 million. $225 million would have been lost, $225 million would
have been won.
By then, this group will really lose their heads. They will probably
write books on “How I Turned a Dollar into a Million in
Twenty Days Working Thirty Seconds a Morning.” Worse yet,
they’ll probably start jetting around the country attending seminars
on efficient coin-flipping and tackling skeptical professors
with, “If it can’t be done, why are there 215 of us?”
But then some business school professor will probably be
rude enough to bring up the fact that if 225 million orangutans
had engaged in a similar exercise, the results would be much
the same—215 egotistical orangutans with 20 straight winning
flips.
I would argue, however, that there are some important differences
in the examples I am going to present. For one thing, if (a)
you had taken 225 million orangutans distributed roughly as the
U.S. population is; if (b) 215 winners were left after 20 days; and if
(c) you found that 40 came from a particular zoo in Omaha, you
would be pretty sure you were on to something. So you would
probably go out and ask the zookeeper about what he’s feeding
them, whether they had special exercises, what books they read,
and who knows what else. That is, if you found any really extraordinary
concentrations of success, you might want to see if you
could identify concentrations of unusual characteristics that might
be causal factors.
Scientific inquiry naturally follows such a pattern. If you were
trying to analyze possible causes of a rare type of cancer—with,
say, 1,500 cases a year in the United States—and you found that 400
of them occurred in some little mining town in Montana, you
would get very interested in the water there, or the occupation of
those afflicted, or other variables. You know that it’s not random
chance that 400 come from a small area. You would not necessarily
know the causal factors, but you would know where to search.
I submit to you that there are ways of defining an origin other
than geography. In addition to geographical origins, there can be
what I call an intellectual origin. I think you will find that a disproportionate
number of successful coin-flippers in the investment
world came from a very small intellectual village that could be
called Graham-and-Doddsville. A concentration of winners that
simply cannot be explained by chance can be traced to this particular
intellectual village.”

Some of these Superinvestors of Graham-and-Doddsville that Buffett mentions include:
Graham, Munger, Schloss, Tweedy Browne, Sequoia Fund, Pacific Partners, Perlmeter Investments.
Some of them also kept a rather low profile, like Walter Schloss, despite his almost 50 year record.

They all show an outstanding record of 10+ years, listed in this 1984 paper.

Now one could argue, that value investing was just one investment style that has incidentally worked for 20+ during that period of time.
Other’s say value investing works because of human nature.

Either way I found Buffett’s point interesting that his group of “smart money” all come from the same zoo.

Best,
fips

12

That essay made me the man I am today.

13

I’ve come to realise that the biggest threat to one’s own performance is human nature.

I think the reality is this: To be successful at investing takes a lot of meticulous analysis of financial statements, balance sheets, cash flows etc. all really quite dull. The payoff of this doesn’t happen immediately- it takes years, but our reward/feedback systems are geared up for much shorter feedback cycles than this, so very few actually become sucessful investors.

Every slight hiccup or glitch is met with questions about “what is wrong”, and invites discussion on glamourous topics such as game theory. This is more interesting, but distracts from what is otherwise quite a dull and sober activity.

14

Oliver,
You make a great point. Perhaps even more than one great point. It is important to be organized, systematic and to not get shaken out of your position when stocks temporarily move against you. I agree with this. To stay the course it is good to have some confidence in your strategy.

The original intent of my question is to question how much confidence one should you have in a strategy. How long will a strategy stay good until others start taking advantage of your predictability. I understand some strategies are better than others in this regard and everyone has made good comments.

15

True story.

In the end we ourselves are our biggest enemies. That’s true for many aspects in life.

This discussion and your comment are even more fitting right now as I am working on a Benjamin Graham style port.
However, I am not sure this can ever be seriously discussed in this community - at least not in terms of commercializing deep value strategies.
Patience pays off and value is robust - but how do you explain that to your sub who sees his port falling for the sixth month in a row when the benchmark goes up?

Best,
fips

16

Just a quick example. One of the first books I read on investing was: “The Way of The Turtle.” BTW this was actually about commodity trading but the breakout strategy has been used for equities, I believe.

Assuming the breakout strategy didn’t work by coincidence, does anyone think it still works? If not, is it just because other people are doing it? Are there some big players that can move the commodity/stock price and “fade” the breakout? I don’t know but I would not try this strategy.

Benjamin Graham’s style seems better to me (and not too glamorous) but it is more difficult to follow now. Value still exists but true “cigar butts” are rare, I have been told.

17

Jim,

The big part here is probably a few things:
a) risk management. Set a volatility and drawdown target for the portfolio as a whole (and the subsystems) and then design the subsystems to fit together and stay within this. We can’t control returns, but if the portfolio vol or DD goes outside the targets, it’s time for a serious review / change. This is the single biggest factor here (to me). If we are getting nervous, we probably have too much exposure.
b) All strategies ‘fail’ - even really common sense one like value or small cap premium - at least all will struggle in some market regimes - so diversify among them and allocate wisely to a basket of them. Some strategies are naturally ‘inversely correlated’ (i.e. long and short big baskets of stocks in the same cap range and sector). They won’t fail together as often - although it’s possible. But some strategies - like value, are much more likely to eventually rebound vs. pure technical trading systems.
c) Consider giving yourself an ‘emotional release’ valve smaller account. I have one smaller account (10% of total port) that I log into A LOT and trade a lot and change systems a lot. The rest of my port I am much more disciplined with. This ‘steam release’ section helps me feel like I’m doing something without hurting my overall port much. And yes, it has underperformed.
d) Keep leverage low enough.
e) Don’t allocate huge chunks of money to ‘new systems’ you haven’t watched or run o-s for a while.

P.S. Many first and second generation ‘turtles’ are still doing very well in the commodity market - there are still at least a half dozen. I check them once a year or so. Most are still using evolved versions of the core systems for some or all of their port’s - but they have evolved to baskets of these systems and changed risk management and other factors, but they also (in many cases) have added a lot of other systems as well. The core idea is still at work and being widely used in CTA’s - but the actual original system as construed doesn’t exist (as far as I know) anymore as the foundation of a CTA.

Best,
Tom

18

[quote]
Benjamin Graham’s style seems better to me (and not too glamorous) but it is more difficult to follow now. Value still exists but true “cigar butts” are rare, I have been told.
[/quote]They still tend to exist in international markets.

FYI, during the Asian debt crisis Warren Buffett bought a basket of Korean cigar butts for his own personal portfolio and made a lot of money. 50%/year if I recall correctly.

Similarly a couple of years ago there were many cigar butts in Japan just before the Japanese stock market went on the QE drug. At that time someone posted a photo of a Japanese stock manual sitting on Warren Buffett’s office desk. I didn’t find out if he actually invested there but it gives you an idea of how he operates. (BTW, no I did not invest in Japan then because my broker (IB) didn’t trade that Japanese exchange yet and because I didn’t have the Japanese stock manual.)

19

Chipper,

Good point. I have seen the same thing with a lot of value investors claiming internationally more attractive ‘cigar butt’s’ (I get several newsletters and/or shareholder reports from value investors and many have been playing globally and claim to find much better deals there). But, first off, I think it’s very different for Buffett:

  1. He has a huge funnel scanning and then sorting through a huge amount of investment opp’s. So, he’s seeing less than 1% of the very best deals before he even starts to work.
  2. He often gets in at great terms.
  3. He can lose billions and be rich. So, he has no real volatility concerns or liquidity needs to speak of.
  4. He has teams to handle the tax implications and the like.
  5. Companies go up simply because he’s bought them and other investors pile in.

I also don’t think he’s really buying total cigar butts - there are several papers on this, but he cares about margins, quality, ‘moat’ and brand strength, etc.

Here’s a note from a) Buffett’s old shareholder letter:
"If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the ‘cigar butt’ approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original ‘bargain’ price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.

You might think this principle is obvious, but I had to learn it the hard way…”

Here’s a blog post from:
http://basehitinvesting.com/net-nets-a-riddle-wrapped-in-mystery-inside-a-cigar-butt/

So… even net-net’s are subject to macro cycles and many other factors. They don’t always make sense.
Bert,
Tom