There's More than One Ball Game

Jan 19, 2007 by

Given a chess board and a set of black and white pieces, different people will play different games. Those who enjoy the complexity of chess will play a game of chess, while those looking for a simpler pastime will use the board and pieces to play a game of checkers. Little kids may toss the pieces in the air and use the board as a hat. A fixed set of elements can be utilized by different people in different manners.

Surprisingly, this also applies to the stock market. Individual investors, financial advisors, and hedge funds buy and sell the same stocks, but do so often in completely different manners, and under different constraints. The varying constraints are financial, institutional, and social.

Constraints on the Individual Investor
Excluding individuals with extraordinary wealth, one constraint on most individual investors is access to capital. As limit orders must be covered (in cash), an individual investor cannot place unlimited limit orders. He is likely to be far more constrained in his placement of limit orders than a financial advisor or hedge fund. Likewise, transaction costs are likely to play a role in his investment strategy. On Scottrade, it costs $7 to sell shares, and $7 to buy. If he has $100 to invest in a stock that is $1/share, he will pay $107 to take the position. Now, imagine the stock goes up 5%. Upon selling the shares, he will receive $105, and have to pay a $7 commission. Thus, he will have spent $107 to receive $98, a (98-107)/107 = -8.4% return. Now, imagine the investor instead invested $1,000 in the stock. He would have paid $1,007 to acquire the shares, and then would have sold them for $1,050, less a $7 commission, to receive $1,043. Thus, his return would have been 3.6%. As you can see in this example, an investor’s ability to trade a large volume and reduce the influence of transaction costs can be the difference between a positive return and losing money. The individual investor may also face constraints on time and speed, as he likely does not spend all of his time observing the market.

Constraints on the Financial Advisor
As a financial advisor is responsible for serving the needs of his clients, he is constrained by his need to serve them. Whenever he wishes to make a trade, he may need to justify his decisions with his clients, who may have different social values or less knowledge of the market than him. Thus, a financial advisor may have trouble investing in highly profitable companies like Altria (formerly Phillip Morris) due to client objections. When the analysts in a financial advisor’s firm give a stock a “sell” rating, he may be forbidden to purchase it for clients. An individual investor can purchase stocks regardless of how they are viewed by analysts. In previous entries, I mentioned how I like to purchase ETFs representing countries hit by natural disasters, as I feel that they sell at depressed prices due to the risk-aversion of individuals. A financial advisor probably could not employ this strategy, as some clients would object to investing in disaster areas due to their own risk-aversion. Due to the consensus-building required of a financial advisor, he may not be able to react rapidly to changing market conditions.

Constraints on the Hedge Fund
Unlike financial advisors, hedge funds do not have to regularly answer to anyone. They are not required to continuously report their holdings, or to tell clients how they have invested their money. As a result, they can exploit both unpopular and rapid trading strategies. One of my friends works in the high-frequency trading division of a large hedge fund. He researches historical data to find patterns in the market that are likely to lead to small returns. As a hedge fund has a large volume of money, it can make a profit on an investment with a 0.01% return, unlike the individual investor mentioned earlier, who in some cases could not even make a profit on a 1% return. Rather than spending time consulting with clients before making trades, hedge funds often use algorithms to trade money automatically. As a result, they can react nearly instantaneously to changing market conditions. On the other hand, there is far less transparency in how hedge funds invest money. Clients are likely to be rather unaware of their present holdings, and to play a far more distant role in the investment of their money.

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