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Who’s selling you that stock?

11072019_who's selling you that stock?

Who’s selling you that stock?

Being successful as an investors requires finding and capitalising on inefficiencies in the market. Perhaps the biggest source of market inefficiency remains the human being – optimism or pessimism – leaving mispriced securities in our wake. Are you paying attention to all relevant information? Or are you over-extrapolating from recent results, leading to unrealistic expectations?

“We regard investing as an arrogant act,” Seth Klarman, the brilliant investor at the helm of The Baupost Group, once mused. While people typically eschew arrogance in their everyday demeanour, it is in fact a necessary, albeit incomplete, part of being successful in investing.

The explanation for this dynamic lies in the nature of transacting in the stock market, and it holds an important lesson for investors when buying or selling stocks.

It is worth reiterating that in every stock purchase, there is someone on the other side selling you that stock. Assuming they are rational actors, and like you, are in pursuit of investment profits, why would they sell you that stock?

The answer is multifaceted, but revolves around the fact that intrinsic value is unobservable and can diverge (sometimes materially) from the market value of a stock. Both investors may be intelligent and hard-working, but they may also hold vastly different opinions on the worth of a particular security.

The arrogance of every investment purchase stems from the fact that you are elevating your own opinion on a stock above that of the person selling the stock to you. The implication is that you believe your information, analysis, and insights are superior to that of the seller on the other side of the trade, and that as a result, you will make money as the stock appreciates in value over time. As investing is a zero-sum game, the seller forgoes that potential gain by selling the stock to you.

The difficulty is that while investing requires a level of confidence in one’s own investment opinions and analytical efforts, the future is uncertain, and this confidence must be tempered with a portion of humility.

Investors must straddle a delicate balance between backing their own research, even in times where the market disagrees and moves wildly in an unfavourable direction, and being cognisant of the fact that they might be wrong. Sensible investing adheres to the strong opinions, weakly held framework developed by the Palo Alto Institute for the Future Director Paul Saffo. A key tenet of this approach is constantly looking for information that doesn’t fit your investment thesis. In effect, you’re trying to disprove your investment thesis. Investing requires constant introspection and pressure testing every thought and decision.

Earlier this year Michael Mauboussin wrote an interesting paper on the topic of capitalising on inefficiencies in the market, and raised the point that if you are buying or selling a security and expect to earn a decent return, you need to be able to answer the question “Who is on the other side?”

In other words, what is your edge relative to the person selling you the stock? This is not an easy question to answer, but is critical to have a grasp of in order to outperform over time. As the saying goes, if you’ve been in a poker game for a while and don’t know who the patsy is, you’re the patsy. The next time you buy a stock, are you confident that your edge is better than the person selling it to you?

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George joined MGIM in September 2015 as a Research Analyst. Prior to joining MGIM, George was an investment analyst at Private Portfolio Managers where he covered global equities across various industries, using a value investing framework. George’s prior experiences include equities research and investment banking roles at both Citi and Greenhill & Co.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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2 Comments

  1. Hi George,
    Great article, one of the most honest articles I’ve read in a while.
    Given the advent in AI & also some pretty smart investment analysts, the group @ RM being up there with the best, how does the average punter:
    (i) differentiate between them to ensure investing success? (given we are continually told previous investment record is no guarantee of future performance)
    (ii) why invest in a fund manager with high fees when, as Buffett said “Consistently buy an S&P 500 low-cost index fund”
    Regards,
    Joe

    • Joe – thanks for the comments and questions. I would say it’s key to focus on the process of the manager and finding someone with an investment philosophy that resonates with your own views/goals around investing.
      Regards,
      George

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