This post is a continuation of my earlier posts. I suggest reading The Art of Selling - Preview and The Art of Selling - Winning the Loser's Game, before you read this post.
Who is on the Other Side?
Does the person on the other side of the trade matter? Why can’t we buy and sell without really caring for ‘who is on the other side of the trade’? The reason (it matters) is that we need to understand the game that the person on the other side is playing. Markets are diverse, every individual market participant has a different attitude towards risk, a different time horizon, different investing style and different information. (We are talking about cognitive diversity here).
For those who are investing and not punting (more on punting in a bit), the following is my best guess as to the process that one should follow to answer the question ‘Who is on the Other Side?’
1. Is the person on the other side a bot or a computerised trading algorithm? By definition, that is someone with a short-term time horizon. As long as my horizon isn’t short term, I can ignore the person on the other side. Reaffirming our time horizon makes decision-making in such situations so much easier.
2. Another question could be, ‘what is it that a machine can’t figure out, but I can?’ This is tough to answer since there is a human mind behind the algorithm.
3. What if the person on the other side isn’t a bot, but a real human being who probably is smarter than I am? Do I have an Edge? We can take comfort, because even the smarties make mistakes.
4. Have I made a fundamental mistake in my decision-making? Are my inherent biases misleading me? Am I wrong?
5. Since I cannot form a good estimate of who is on the other side, after asking all the above questions or in some other manner, would it be wise to do nothing instead?
Mostly, the correct answer is 4 or 5 above. If one has made a fundamental mistake, the selling decision is straightforward - get the hell out. Hope cannot be a strategy. The underlying assumption is that one has been diligent before placing the BUY order.
All the above is for the long-term investor, and that is a rare breed in today’s momentum driven markets. Almost every person who I ask says they are long-term investors. If most of the market participants do indeed have long term time horizons, who the hell accounts for the daily global turnover of trillions of dollars?
In reality, a large percentage of so-called investors are, in fact, using momentum as their ‘investing’ strategy. All of us shouldn’t even be calling it ‘investing’. Punting is a better word.
And, to be sure, there isn’t anything wrong with punting or using momentum as a strategy (been there, done that). But the rules of the investing game don’t apply to any momentum driven strategies.
Momentum as a Strategy
Market momentum as a strategy isn’t a new discovery, it is as old as the hills. Unbeknownst to most, the great economist, Lord Keynes, was a momentum investor until he went bankrupt. He re-engineered his strategy to become one of the most successful stock market investors of all time. Most of us associate Lord Keynes with his work in economics, but his stock market success isn’t as well known.
What is known as momentum investing as on date is what Keynes called ‘credit cycle investing’ and this is how he described it:
I can only say that I was the principal inventor of credit cycle investment and have seen it tried by five different parties acting in detail on distinctly different lines over a period of nearly twenty years, which has been full of ups and downs; and I have not seen a single case of a success having been made of it. Keynes thought that credit cycling not only demanded "abnormal foresight" and required "phenomenal skill to make much out of it," but that transaction expenses from such a necessarily active investment policy tended to erode trading profits.
He expanded on this theme in a memorandum to the King's College Estates Committee: . . . I am clear that the idea of wholesale shifts [out of and into stocks at different stages of the business cycle] is for various reasons impracticable and indeed undesirable. Most of those who attempt it sell too late and buy too late, and do both too often, incurring heavy expenses and developing too unsettled and speculative a state of mind.
In layman's terms, what Keynes is pointing at is the fact that any momentum investing strategy involves forecasting the psychology of the market - which means forecasting the psychology of other market participants. It involves a two-step process, wherein we first try to judge market sentiment. We then use that as our best guess whether we should buy or sell. This is the 'process' that Keynes has described above. Reality is a bit nuanced. Some great man has said, ‘Whoever is winning at the moment will always seem to be invincible’ - the stock that has the highest momentum is the one that looks most attractive to a momentum driven investor and that is the name that we end up buying or selling.
Since mood and momentum drives our process, the key task is to time the purchase and sale of securities. Success is little more than anticipating the anticipations of others. The idea is to foresee changes in the conventional basis of sentiment and liquidity, a short time ahead of the public - to BUY before the crowd does, and to then SELL to the crowd. Trying to guess mob psychology is next to impossible in almost any context. I haven’t heard of any market participant who has done this consistently over the long-term. But that doesn’t stop us from trying, does it? Our so-called investing process requires us to anticipate something as fluid and capricious as mob psychology. How absurd is that?
What kind of mindset should we build, if we want to day trade or position trade? How should we form an opinion of who is on the other side in such cases?
1. Momentum as a strategy is about what is happening in real time and not why it is happening. Hence, the price of the instrument is the ONLY thing that matters. The problem is that we keep getting fooled by the randomness of the price action.
2. Momentum investors are those who are in the game to make a quick buck. In the momentum game, ‘who is on the other side’ doesn’t matter at all.
3. When a price moves out of a trading range, it is called a breakout. In situations where such breakouts occur for reasons that nobody understands, the risk-reward ratio favours reward over risk. Breakouts that occur because there is a story in the newspapers are less relevant. The lesser the explanation for a price move, the better it looks. The more a price pattern is observed by speculators, the more prone you are to have false signals.
While riding the momentum, when the underlying trend changes, we get ‘stuck’ in a trade. That is when we ask: Who is on the other side? What we have done is to convert a momentum trade in to a long-term investment. Some of these kinds of trades work out, but mostly, they don’t. So, the ‘poor little momentum driven investor’ gets suckered into an investment - because ‘they’ sold when he or she bought or vice versa.
Marginal Trades
Since an overwhelming majority of ‘investors’ are flipping stocks, the twin concepts of a Marginal Buyer and a Marginal Seller are relevant for the genuine long-term investor.
A Marginal Buyer is one who will pay a huge premium to the consensus estimate of what a business is worth (Greed). And, a Marginal Seller is one who will sell at a huge discount to the same consensus estimate (Fear). To make it even more clear, a long-term investor always wants to BUY FROM the marginal seller, and wants to SELL TO the marginal buyer. This isn’t easy in real-time. I mean, there are no bells and whistles that get blown announcing these kinds of trade. With the benefit of hindsight, these trades look easy.
In the first half of the calendar year 2020, we had an avalanche of marginal sellers. As a result, it was relatively easy to pick stocks. The ‘person on the other side’ was willing to sell at ridiculously low prices, out of sheer panic. As on date, a lot of momentum driven investors are looking like geniuses, riding the momentum. Some amount of caution is warranted since we shouldn’t confuse brains with a bull market. The wealth effect can dissipate quickly - it ain't over till it's over.
Today, we are in the opposite situation - there is an entire army of marginal buyers - those who will pay ridiculously high prices. For the genuine long-term investor, the current scenario is tricky. He (or she) isn’t a buyer of stocks and if he (or she) is, it is a very selective approach. Most long-term investors who are sitting on gains are inclined to sell instead, the do something syndrome - ‘don’t just sit there, do something’. In the stock market, it might be a better idea to invert that which is to say, 'don’t just do something, sit there'.
There is an internet hash tag that goes by the name of ‘never sell’ or something similar. I don’t buy the ‘Never Sell’ mantra. So, we need to be asking the right questions when we take a selling decision. I will write about those in the next post.
Click here to go back to The Art of Selling - Index
To view this post in your browser or to share it click Who is on the Other Side?
Who is on the Other Side?
Does the person on the other side of the trade matter? Why can’t we buy and sell without really caring for ‘who is on the other side of the trade’? The reason (it matters) is that we need to understand the game that the person on the other side is playing. Markets are diverse, every individual market participant has a different attitude towards risk, a different time horizon, different investing style and different information. (We are talking about cognitive diversity here).
For those who are investing and not punting (more on punting in a bit), the following is my best guess as to the process that one should follow to answer the question ‘Who is on the Other Side?’
1. Is the person on the other side a bot or a computerised trading algorithm? By definition, that is someone with a short-term time horizon. As long as my horizon isn’t short term, I can ignore the person on the other side. Reaffirming our time horizon makes decision-making in such situations so much easier.
2. Another question could be, ‘what is it that a machine can’t figure out, but I can?’ This is tough to answer since there is a human mind behind the algorithm.
3. What if the person on the other side isn’t a bot, but a real human being who probably is smarter than I am? Do I have an Edge? We can take comfort, because even the smarties make mistakes.
4. Have I made a fundamental mistake in my decision-making? Are my inherent biases misleading me? Am I wrong?
5. Since I cannot form a good estimate of who is on the other side, after asking all the above questions or in some other manner, would it be wise to do nothing instead?
Mostly, the correct answer is 4 or 5 above. If one has made a fundamental mistake, the selling decision is straightforward - get the hell out. Hope cannot be a strategy. The underlying assumption is that one has been diligent before placing the BUY order.
All the above is for the long-term investor, and that is a rare breed in today’s momentum driven markets. Almost every person who I ask says they are long-term investors. If most of the market participants do indeed have long term time horizons, who the hell accounts for the daily global turnover of trillions of dollars?
In reality, a large percentage of so-called investors are, in fact, using momentum as their ‘investing’ strategy. All of us shouldn’t even be calling it ‘investing’. Punting is a better word.
And, to be sure, there isn’t anything wrong with punting or using momentum as a strategy (been there, done that). But the rules of the investing game don’t apply to any momentum driven strategies.
Momentum as a Strategy
Market momentum as a strategy isn’t a new discovery, it is as old as the hills. Unbeknownst to most, the great economist, Lord Keynes, was a momentum investor until he went bankrupt. He re-engineered his strategy to become one of the most successful stock market investors of all time. Most of us associate Lord Keynes with his work in economics, but his stock market success isn’t as well known.
What is known as momentum investing as on date is what Keynes called ‘credit cycle investing’ and this is how he described it:
I can only say that I was the principal inventor of credit cycle investment and have seen it tried by five different parties acting in detail on distinctly different lines over a period of nearly twenty years, which has been full of ups and downs; and I have not seen a single case of a success having been made of it. Keynes thought that credit cycling not only demanded "abnormal foresight" and required "phenomenal skill to make much out of it," but that transaction expenses from such a necessarily active investment policy tended to erode trading profits.
He expanded on this theme in a memorandum to the King's College Estates Committee: . . . I am clear that the idea of wholesale shifts [out of and into stocks at different stages of the business cycle] is for various reasons impracticable and indeed undesirable. Most of those who attempt it sell too late and buy too late, and do both too often, incurring heavy expenses and developing too unsettled and speculative a state of mind.
In layman's terms, what Keynes is pointing at is the fact that any momentum investing strategy involves forecasting the psychology of the market - which means forecasting the psychology of other market participants. It involves a two-step process, wherein we first try to judge market sentiment. We then use that as our best guess whether we should buy or sell. This is the 'process' that Keynes has described above. Reality is a bit nuanced. Some great man has said, ‘Whoever is winning at the moment will always seem to be invincible’ - the stock that has the highest momentum is the one that looks most attractive to a momentum driven investor and that is the name that we end up buying or selling.
Since mood and momentum drives our process, the key task is to time the purchase and sale of securities. Success is little more than anticipating the anticipations of others. The idea is to foresee changes in the conventional basis of sentiment and liquidity, a short time ahead of the public - to BUY before the crowd does, and to then SELL to the crowd. Trying to guess mob psychology is next to impossible in almost any context. I haven’t heard of any market participant who has done this consistently over the long-term. But that doesn’t stop us from trying, does it? Our so-called investing process requires us to anticipate something as fluid and capricious as mob psychology. How absurd is that?
What kind of mindset should we build, if we want to day trade or position trade? How should we form an opinion of who is on the other side in such cases?
1. Momentum as a strategy is about what is happening in real time and not why it is happening. Hence, the price of the instrument is the ONLY thing that matters. The problem is that we keep getting fooled by the randomness of the price action.
2. Momentum investors are those who are in the game to make a quick buck. In the momentum game, ‘who is on the other side’ doesn’t matter at all.
3. When a price moves out of a trading range, it is called a breakout. In situations where such breakouts occur for reasons that nobody understands, the risk-reward ratio favours reward over risk. Breakouts that occur because there is a story in the newspapers are less relevant. The lesser the explanation for a price move, the better it looks. The more a price pattern is observed by speculators, the more prone you are to have false signals.
While riding the momentum, when the underlying trend changes, we get ‘stuck’ in a trade. That is when we ask: Who is on the other side? What we have done is to convert a momentum trade in to a long-term investment. Some of these kinds of trades work out, but mostly, they don’t. So, the ‘poor little momentum driven investor’ gets suckered into an investment - because ‘they’ sold when he or she bought or vice versa.
Marginal Trades
Since an overwhelming majority of ‘investors’ are flipping stocks, the twin concepts of a Marginal Buyer and a Marginal Seller are relevant for the genuine long-term investor.
A Marginal Buyer is one who will pay a huge premium to the consensus estimate of what a business is worth (Greed). And, a Marginal Seller is one who will sell at a huge discount to the same consensus estimate (Fear). To make it even more clear, a long-term investor always wants to BUY FROM the marginal seller, and wants to SELL TO the marginal buyer. This isn’t easy in real-time. I mean, there are no bells and whistles that get blown announcing these kinds of trade. With the benefit of hindsight, these trades look easy.
In the first half of the calendar year 2020, we had an avalanche of marginal sellers. As a result, it was relatively easy to pick stocks. The ‘person on the other side’ was willing to sell at ridiculously low prices, out of sheer panic. As on date, a lot of momentum driven investors are looking like geniuses, riding the momentum. Some amount of caution is warranted since we shouldn’t confuse brains with a bull market. The wealth effect can dissipate quickly - it ain't over till it's over.
Today, we are in the opposite situation - there is an entire army of marginal buyers - those who will pay ridiculously high prices. For the genuine long-term investor, the current scenario is tricky. He (or she) isn’t a buyer of stocks and if he (or she) is, it is a very selective approach. Most long-term investors who are sitting on gains are inclined to sell instead, the do something syndrome - ‘don’t just sit there, do something’. In the stock market, it might be a better idea to invert that which is to say, 'don’t just do something, sit there'.
There is an internet hash tag that goes by the name of ‘never sell’ or something similar. I don’t buy the ‘Never Sell’ mantra. So, we need to be asking the right questions when we take a selling decision. I will write about those in the next post.
Click here to go back to The Art of Selling - Index
To view this post in your browser or to share it click Who is on the Other Side?