After initial plunges due to the Ukraine invasion, most markets regained composure. S&P ended 1.5% higher, making a spectacular intraday recovery. Asian markets rebounded somewhat in the morning and early afternoon sessions.
Is the invasion really a totally benign event not affecting the global economy at all? Definitely not. There are several good write-ups on it, such as this article from Financial Times and this from The Economic Times. The global economy would take perhaps a 0.2-0.3% GDP hit over the next few years, but risks have increased, especially with the oil/inflation aspect. The situation is definitely worse due to the invasion, but there is still considerable uncertainty regarding how much worse.
More certainty would arrive as the situation develops further within the next few days, weeks or months. If you are confident of the long-term prospects of your stock, it might be a good buying opportunity. Meanwhile, this is a good chance to practice managing greed and fear. Fear was abundant yesterday, but greed has been in play for much of today. Most of the time, giving in to extreme fear or greed will lead to unprofitable outcomes.
Russia has formally launched a military operation in Ukraine. Dow futures are about 500 points off. Stocks are tanking. Gold and oil prices have spiked upwards. In these situations, it is more important than ever to keep your emotions in check, and avoid impulsive actions.
If you can stay logical, do read up as much as you can on this situation, and monitor news flow closely. It will help you determine what stocks to buy and sell, and also the timing to do so.
Conversely, if you feel that your emotions may cloud your judgment, please do the opposite and stay away from media reports on the markets. Do something to distract yourself. But try not to take too long to return to the markets. Opportunities may present themselves during this volatility that may not last long.
Do remember that in addition to asset prices fluctuations, there will also be some changes in stock/industry fundamentals. Thus it will be prudent to revisit the investment/trading cases for the stocks you already have or are interested in acquiring.
Retail investors are always seen as the perennial underdogs against institutional investors. Indeed, institutional investors have significant advantages over the average man in the street. However, retail investors can still be successful and perform well in the markets, given the right knowledge and frame of mind.
What are Retail Investors Up Against?
Institutional investors are people employed by companies/organizations to make trades in the markets. These organizations include banks, insurance companies, mutual funds and hedge funds. With their large budgets, economies of scale and corporate connections, they are able to:
Obtain faster, more in-depth info
fundamental research in companies, sectors, economic trends
price-moving events in real-time
alternative economic indicators (eg. satellite images, railway traffic)
Invest in the best hardware and software
Trade more cheaply
their large volumes allow them to command lower fees
Hire good traders/investors with proven track records
Provide expensive/specialized training
Why Retail Investors Still Can Compete
There are several reasons why retail investors should still be able to compete with institutional investors despite their huge advantages listed above:
Complexity of the Markets
Size and Variety of Markets
Constraints of Institutional Investors
Agility and Flexibility of Retail Investors
Complexity of Markets
The markets are made of many moving parts. Many variables affect the price of assets, some are difficult to quantify while others may not even have an obvious relation to an asset. This underscores the difficulty of predicting asset price movements.
Major financial institutions have many years in the industry, and also possess some of the best talents. And yet they get their target prices for stocks wrong more often than they get it right. Since no one can very accurately predict stock prices, no one can dominate, and hence everyone in the game still has a chance.
Size and Variety of Markets
There are many asset classes in many markets, spread across many sectors and occupying different niches in their locale. New assets are being created everyday, adding to the colour and diversity of the markets.
With such a huge number of possible assets to trade or invest in, there would always be some which are not traded by institutional investors yet. Also, retail investors may be able to explore and find a niche in which they are familiar with and have an edge.
Constraints of Institutional Investors
Institutional investors invest/trade in huge amounts. This means that companies with small market capitalizations and those with low liquidity are not appropriate candidates for them.
They are also often not able to buy or sell stocks at one go, as their orders may fill up the current price level and slip into the next price level(s). They may need to split up into several different orders, sometimes across different days.
There may be mandates from management preventing them from investing in the stocks they prefer, for example ESG mandates. They may also need to buy an asset which they may not particularly like, perhaps for maintaining fund composition requirements.
Agility and Flexibility of Retail Investors
Retail investors deal in small amounts. They are able to invest in small cap and illiquid stocks. Their orders can be filled easily within the current price level, thus they have no problems buying/selling quickly.
They also do not have any constraints on the type of investments to make (eg. ESG mandates, fund composition). Also, there is no need to force a trade/sale if there are no good options around, they can wait until an opportunity arises.
What Retail Investors Can Do To Compete With Institutional Investors
Retail investors should aim to minimize the advantages institutional investors have over them, and maximize their own advantages over them.
Research to reduce information gap
Explore freely to find areas you perform well in
Be patient and do not force trades
Be nimble and react to fundamental changes quickly
Research to Reduce information gap
With the advent of the Internet, retail investors can now access a lot of information for free. They can diligently research on the stocks and sectors of interest to keep themselves updated. It is also useful for getting near real-time updates for time-sensitive trades.
Free information sources can probably give you about 60 to 70 percent of the info that institutional investors receive. To gain more specialized information, retail investors can subscribe to dedicated financial sites. Sometimes, this is necessary in order to gain more knowledge in depth in certain areas, and increase your chances of developing a trading/investing edge.
Explore freely to find areas you perform well in
Retail investors are free to try out any trading techniques and strategies in any areas of the market, without needing to seek permission and report results. They should keep learning about new assets and instruments, and not be afraid to try them out.
Be patient and do not force trades
Being able to wait for a while for a good trade will guarantee a higher probability of success than being forced to make suboptimal trades. Retail investors have the luxury of not making trades for weeks, months or even sometimes years. They should take advantage of this privilege to make fewer but higher quality trades. This will lead to a higher percentage of winning investments.
Be nimble and react to fundamental changes quickly
Retail investors can enter and exit a position easily in just 1 or 2 trades most of the time. Institutional investors trade in large sizes, and have to enter or exit a position gradually over time. This is to ensure that their trades do not cause prices to shift and cause them to transact at unfavourable prices.
This means that retail investors are a lot more agile, and can establish or exit a position much quicker, most often on the same day. In contrast, an institutional investor owning perhaps 10% to 15% of the entire company has to take some time to entirely dispose of a position.
Retail investors should regularly monitor news flow, and react decisively on any fundamental-altering event once some research has been done to ratify its legitimacy and impact. For example, if a major coal-using country decides to ban coal imports and make a major push towards natural gas and renewables, it would be optimal to cut positions in coal miners as soon as possible.
Conclusion
As of current market conditions, retail investors still have a good chance of doing well in the markets against the institutional investors. They just need to choose their battles well and be willing to put in time and effort to hone their edge.
This may change in the future, depending on how the nature of the markets changes and how unequally technology advancements benefit retailers/institutions. However, no one can predict the future accurately, so there is no need for retail investors to worry about it at the moment. The sun is still bright for them, so they can focus on making hay while the sun shines.
A trading edge is an aspect/area of trading in which you are better than most others at, and which allows you to profit consistently from trading. It may not necessarily encompass merely a specific technique or fixed set of techniques, but may also include the approaches adopted to handle the technical, strategic and mental aspects of trading.
Most of this article is relevant to investing edge as well. There is a fine line between investing and trading, and sometimes the boundaries are blurred and overlapping.
Why do you need a Trading Edge
Without a trading edge, it would be difficult to make enough money from trading to make a difference in your life. This is because trading is a negative sum game – the players have a less than 50% chance of profits on average because of the fees imposed by the various middlemen (eg. transaction fees, holding fees, trading platforms, stock exchanges, financial institutions). Thus if you are an merely average player in this game, you have a less than 50% chance of making consistent profits.
Arguably, if you are trading/investing over the long term, the game becomes a positive sum game, where the average player has a more than 50% chance of profits. This is because of the effects of technological progress and efficiency gains in companies over time. However, you are unlikely to make life-changing amounts simply by banking on these effects.
How do you develop a trading edge?
There are 4 things you need to work on concurrently.
Understand what drives asset prices
Understand the methods to trade the markets
Experiment to find out what works for you
Work on honing your cognitive skills
1. Understand what drives asset prices
Understand how markets work and what makes stock/asset prices go up or down. A lot of information is already on mainstream media free, so a reasonable understanding can be obtained from websites and videos.
Do note that you would need to regularly measure a pulse of the markets by constant research, as market behavior changes constantly.
2. understand the methods to trade the markets
There are various instruments available to trade markets, for example regular stock purchasing, options, CFDs, Daily Leverage Certificates. And there are various ways to utilize them, either within themselves or in combination with each other. The characteristics of each method should be studied, for example one-time costs, holding costs, leverage, break-even point etc. In addition, it would also be good to know the expected pattern of results of each method (eg. buying options typically results in more losses of smaller amounts, but also wins of greater amounts).
An example of an analysis of trading methods can be found in my previous post here.
3. Experiment to find out what works for you
Basically, be like a mad scientist and try out many different ideas. Test out different instruments using different strategies across different asset classes. But please do it without bankrupting yourself in the process. Use demo accounts first, but if you find demo experience not useful at all, go with live accounts, but trade with small amounts first.
4. Work on honing your cognitive skills
Your cognitive skills are used to assimilate info, develop strategies, recognize patterns and trends, identify correlations and learn from experiences. With more honed cognitive abilities, you would have a higher chance finding an edge, and your edge would be sharper.
There are many ways to improve cognitive abilities. There is a good article on it here. Personally, I find that computer games involving problem-solving and monitoring/managing different data points are useful in this aspect.
How Long Will It Take To Develop A Trading Edge?
Like any other skill, it will take a lot of time and effort. You may have heard of the “10,000 hours rule” to master a skill. The truth is, there are a lot of variables affecting learning speed, and not everybody will take the same time to develop an edge. Some may take months, while others may take years.
Will I be able to Develop A Trading Edge By Copying A System/Approach Already Used By Other Traders?
It is unlikely for 2 reasons:
Your trading edge likely has to be customized for your own cognitive and personality traits
If a system/approach has been copied and used widely, it likely would lose its competitive advantage
It can still be useful to look at other successful systems/approaches. You can adapt parts of them to fit into your strategy.
How Long Will Your Trading Edge Last?
It really depends on how markets evolve and the nature of your trading edge. They can last for less than a year, or they can be effective even after many years. Markets do evolve, and it is unlikely that any trading edge can last forever. You can try to maintain its effectiveness over time by continually tweaking it to cater for changing market behavior. If tweaking does not work anymore, it would be wise to move on to find another trading edge.
Conclusion
Being able to develop and maintain trading edges is key to being a successful trader. It will definitely take a lot of work, but the end result will be worth it.
When you have developed your edge, it is important to stay humble and recognize that market dynamics can change anytime and render your edge useless. Conversely, if you have not yet developed your edge, just keep learning and trying different things, your breakthrough may yet come soon.
Since my last post 2 weeks ago, the price of iron ore has surged further from about $124 to as high as $148. It is currently at about $137. The surge is all based on hope that demand will improve, fundamentals have not improved at all.
China has just stated its intention to suppress the iron ore speculators driving up prices. Could this be the start of a sentiment shift? It is possible, though there may not be a straight one-way journey down. China did the same thing last year, and prices went down, back up and then down again. In my opinion, the fundamentals of supply and demand will matter most in the end. Thus it is best to monitor news flow pertaining to them, in order to gain clues on medium to long term price direction.
If you are itching to trade iron ore equities, in my opinion the downside risk-reward ratio is more attractive than the upside. Do note that this week the Chinese are on holiday, so the number of traders is smaller, which would imply greater unpredictability of the price action.
