Yes, there is class of investment strategies which go by the name of “liquidity constrained”. If there is a small… market inefficiency out of which you can extract, say, $100,000/year but no more, none of the big investment firms would bother—it’s not worth their time. But for an individual it often is.
Can you please say more about these and how to find them?
Liquidity is a characteristic of a financial asset which, without going into technicalities, is an indicator of how quickly and how cheaply can one buy or sell large amounts of this particular asset in the open market.
Some assets—like the common stock of Apple or US Treasury bills—are very liquid. There is a continuous market, very large volumes are changing hands daily, and orders to buy and sell are filled rapidly, with low transaction costs and without pushing the market.
Some assets—like specific bonds or, say, tracts of land in Maine—are not liquid. Buying or selling them will take time and will be expensive in terms of transaction costs. If you want to buy (or sell) a lot of these, you will likely push the market (if you’re buying you’ll push the price up, if you’re selling you’ll push the price down), sometimes considerably so.
The problem with investment strategies which rely on buying and selling illiquid assets is that they do not scale. You might be able to achieve high returns on small amounts of capital, but you cannot put more capital into this trade because the trade will then break. Hedge funds and such are not interested in investment strategies which do not scale because it’s too few dollars for too much hassle.
What this means is that trade opportunities in small, obscure, illiquid niches of financial markets are not exploited by the big fish and so could remain “open” for a long time. Remember that the self-adjusting feature of the market is not magic, it only works if somebody does commit capital to “fixing” the market inefficiency. If no one does, the inefficiency does not go away on its own.
This implies that if you search the (preferably obscure) little nooks and crannies of markets, your chances of finding a free lunch are much higher than in popular, liquid markets that everyone likes to play in.
Two warnings, though. First, what appears to be free cheese might turn out to be located in a mousetrap. Examine the circumstances carefully. Second, niche markets often have local players which understand this particular market better than you do, so see the first point.
What this means is that trade opportunities in small, obscure, illiquid niches of financial markets are not exploited by the big fish and so could remain “open” for a long time.
Could you give examples of what you mean that existed a few years ago and that are now exploited, so that no further money can be made and you don’t lose something be openly sharing the information?
I’m not sure that hiring a bunch of people to do annoying phone calls is what Lumifer has in mind when he talks about trading opportunities in illiquid niches of the financial markets.
This implies that if you search the (preferably obscure) little nooks and crannies of markets, your chances of finding a free lunch are much higher than in popular, liquid markets that everyone likes to play in.
Do you believe that people without special expertise are capable of finding and evaluating those opportunities?
The question is ill-defined, it’s like asking in how many hours can you learn to program in, say, R. The answers can plausibly range from “a few hours” to “a lifetime”.
Besides, in this case some skills will be general (e.g. risk management), equivalent to the ability to code, and some will be very very specific (e.g. knowledge of the regulatory regime in a particular narrow field), equivalent to understanding some library very well.
Can you please say more about these and how to find them?
Liquidity is a characteristic of a financial asset which, without going into technicalities, is an indicator of how quickly and how cheaply can one buy or sell large amounts of this particular asset in the open market.
Some assets—like the common stock of Apple or US Treasury bills—are very liquid. There is a continuous market, very large volumes are changing hands daily, and orders to buy and sell are filled rapidly, with low transaction costs and without pushing the market.
Some assets—like specific bonds or, say, tracts of land in Maine—are not liquid. Buying or selling them will take time and will be expensive in terms of transaction costs. If you want to buy (or sell) a lot of these, you will likely push the market (if you’re buying you’ll push the price up, if you’re selling you’ll push the price down), sometimes considerably so.
The problem with investment strategies which rely on buying and selling illiquid assets is that they do not scale. You might be able to achieve high returns on small amounts of capital, but you cannot put more capital into this trade because the trade will then break. Hedge funds and such are not interested in investment strategies which do not scale because it’s too few dollars for too much hassle.
What this means is that trade opportunities in small, obscure, illiquid niches of financial markets are not exploited by the big fish and so could remain “open” for a long time. Remember that the self-adjusting feature of the market is not magic, it only works if somebody does commit capital to “fixing” the market inefficiency. If no one does, the inefficiency does not go away on its own.
This implies that if you search the (preferably obscure) little nooks and crannies of markets, your chances of finding a free lunch are much higher than in popular, liquid markets that everyone likes to play in.
Two warnings, though. First, what appears to be free cheese might turn out to be located in a mousetrap. Examine the circumstances carefully. Second, niche markets often have local players which understand this particular market better than you do, so see the first point.
Could you give examples of what you mean that existed a few years ago and that are now exploited, so that no further money can be made and you don’t lose something be openly sharing the information?
During the 80′s and 90′s a number of firms sprouted up around buying and selling penny stocks via strategies like cold calling.
I’m not sure that
hiring a bunch of people to do annoying phone callsis what Lumifer has in mind when he talks about trading opportunities in illiquid niches of the financial markets.Here’s an example that did not scale well: The New York Time Magazine: Paper Boys
I don’t think that the article says something about problems that come with scale. It rather suggests that the first attempts were lucky.
There are also ethical issues with the business model of buying up debt and then hiring ex-convicts to collect that debt.
Another, much smaller, example.
Edit:typo.
I don’t think that’s an example of someone investing money into an asset. It’s a bet on default rates not changing.
Do you believe that people without special expertise are capable of finding and evaluating those opportunities?
What’s “special expertise”? Like most everything in life, this requires the capability and the willingness to learn and figure things out.
How many hours do you think the average person on LW would need to invest to pick up the relevant skills?
The question is ill-defined, it’s like asking in how many hours can you learn to program in, say, R. The answers can plausibly range from “a few hours” to “a lifetime”.
Besides, in this case some skills will be general (e.g. risk management), equivalent to the ability to code, and some will be very very specific (e.g. knowledge of the regulatory regime in a particular narrow field), equivalent to understanding some library very well.