Who’s selling you that stock?

“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 Hadjia is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.

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