Retail Investor Advantages
There are some advantages to being a retail investor that might make it possible for you to beat the market without violating EMH.
Information Acquisition Cost
If you are an expert in some domain, it costs less for you to assess information in that domain than some trading firm. The trading firm has to spend money and suffer a time delay hiring an expert, incur the costs of communication overhead between people being difficult, also spend money on the opportunity cost of context switches and taking time away from traders at the company etc. Meanwhile, because you have both the trader and expert in your head, you save on a huge amount of overhead. Similarly, trading firms could pay people to camp outside Walmart and count customers, but if you already work at Walmart you can observe these things for relatively little marginal cost. Because of this, there are many small niches where the possible reward is too small to make it worth it for a trading company, but whose stakes are just the right size for retail investors.
Cheaper Liquidity
Nobody wants to be on the other side of the trade with RenTech, because RenTech makes smart trades. Everyone wants to be on the other side of the trade with retail investors, because most are uninformed and generally lose money over time. This is what makes it possible for Robinhood to offer commission free trades; uninformed flow is something that market makers really want to be on the other side of. The magnitude of trading fees often make or break a trading strategy.
Less Slippage
Moving less money moves the market less. As you scale up your Assets Under Management, your moves eat deeper into the order book and cause the market to move with you, eroding your profits. Large funds have entire teams of people dedicated to trade execution strategies to minimize their impact on the market. As a retail investor, you don’t have this problem to the same magnitude; buying $100k of SPX will move the market a negligible amount. The magnitude of slippage also often makes or breaks a trading strategy; many naive backtests ignore slippage (because historical order book information is typically more difficult to obtain than OHLCV), and end up unprofitable in the real world because of it.
(Nothing I post is financial advice, I am not a financial advisor, etc)
Two of those “advantages” aren’t as much “advantages” as the market telling you that it thinks it knows better than you. The fact that you have lower trading costs and lower slippage (actually the same thing) is because the market doesn’t respect you.
Re: information acquisition cost. Sure, you might have one small piece of information that BigTradingFirm doesn’t have, but they have plenty of information you don’t have. The relative value of the information is what matters.
To elaborate on the information acquisition cost point; small pieces of information won’t be worth tying up a big amount of capital for.
If you have a company worth $1 billion and you have very good insider info that a project of theirs that the market implicitly values at $10 million is going to flop, if the only way you can express that opinion is to short the stock of the whole company that’s likely not even worth it. Even with 10% margin you’d be at best making a 10% return on capital over the time horizon that the market figures out the project is bad (maybe O(1) years), and that mean return would come with way more risk than just buying into the S&P 500, so your Sharpe would be much worse.
In general this kind of trading is only worth it if your edge over the market is big enough. If you just know something the market doesn’t know that’s not very useful unless you can find someone to bet on that exact thing rather than have to involve a ton of other variance in your trades, and even if you try to do that people can figure out what you’re up to and refuse to take the other side of your trades anyway.
“Sure, you might have one small piece of information that BigTradingFirm doesn’t have, but they have plenty of information you don’t have. The relative value of the information is what matters.”
As an example, let’s say you’re a scientist who works in the field of bioprinting. A new company IPOs, planning to make artificial tissue for transplant via bioprinting. You’ve been working with similar technology for 25 years, know the founder personally, and are certain that the tech won’t work and the founder’s a dishonest-yet-charismatic person with a history of exploiting others to make themselves look good. So you short the stock.
A hedge fund doesn’t have your experience. But they do have lots of information about your industry, historical performance of companies in this sector, advisors (including from your peers), regulatory insight, and much more. They understand that the CEO can be replaced, the product can pivot, etc. They have better overall judgment about how to weigh and synthesize all the information about the company into a prediction about where the price will go.
Suppose as a domain expert you highly suspect company X will fail within timeframe Y. This company is pretty small and there is a reasonable amount of irreducible uncertainty so you (or anyone else) could make a maximum of $10k off of this bet. It costs you ~nothing on the margin to take this opportunity, but it would cost BigFund more than $10k in opportunity cost to acquire this information and act on it, so it’s not worth it to them to bother with it.
Also, the market underestimating me is a good thing for my bottom line.
I think the main advantages retail has are:
Potentially long time horizons. Your trade doesn’t have to look good in time for bonus season. You can be under water for years on a long term bet that pays off, and you don’t have to justify yourself to anyone.
Relatedly, you can invest in weird things. A lot of individual investors figured out that Bitcoin or Eth were good buys before it was professionally acceptable for fund managers to invest. (And in some cases the constraints are not just social / reputational, but also legal — there are restrictions on what assets fund managers can invest in.)
Small size means you can look for opportunities with a good return, but low capacity (e.g. some opportunity that could turn 10k into 20k, but couldn’t turn 10M into 20M). I think this is a much bigger deal than the low slippage advantage that comes from small size.
EDIT: I suppose my point #3 is the same as the point you are making here (I just emphasize that it’s about opportunities with good returns and low capacity, rather than information acquisition costs in general):
I’m kinda curious as to what sort of opportunities people think these are (especially in developed markets)
The sorts of things which have low enough variance to be “good” trades without doing them systematically would require large, concrete mispricings. I struggle to see how the opporunity is limited to ~$10k in those cases?
Where there are regular opportunities to turn $10k into $20k, I can assure you that that is not “too small” for trading firms. At the extreme, and HFT trading 1-lots is quite happy to trade things with tiny $ edge, but doing them at scale.
(Strongly agree with you re: weird things and time horizon though, they are definitely the biggest edges I can think of for retail)
These opportunities are going to be especially not in developed markets. Or not things that a firm can do systematically.
I agree that 10k (or much less) profit per trade is not too small for an HFT shop, if it’s part of an overall strategy that does many trades. The capacity of a trading strategy isn’t how much it makes per trade, but how much capital you can productively allocate to it over its lifetime. And a firm is not going to devote weeks of an employee’s time to developing a strategy that’s only ever going to make 10k.
Instead, I’m thinking of weird, one-off things like:
taking advantage of credit card sign-up bonus arbitrages
deciding that a particular house for sale (not the whole housing sector) is undervalued
speculating on a rare book, or piece of art, or other collectible
betting on obscure cryptocurrencies that you’ve done some analysis of
taking advantage of DeFi yield farming schemes
These are generally going to be weird small things that a traditional firm can’t easily trade in a systematic way, such that it’s not worth their time to look into them.
Note that it might not be worth the retail investor’s time either, depending on how they value their time and their opportunity costs. But in some cases I think you can stumble upon knowledge that you can then take advantage of, without worrying that your knowledge / reasoning is mistaken because there shouldn’t be a $20 bill on the sidewalk. If you stumble upon some information that makes you think the S&P500 is undervalued, you should be a lot more skeptical of that than of some analysis that suggests some obscure collectible / penny stock / cryptocurrency / NFT is undervalued.
Okay, but your examples are now all the same as your “2.” (which I don’t disagree with). Size isn’t the advantage here, it’s being able to be involved in weird things. (I was disagreeing with your point “3.”)
Fair enough. I suppose I’m having trouble coming up with examples of opportunities that are both not weird, and also not systematizable. (Though I do think evaluation of individual penny stocks counts.)
I’m keeping that as separate from 2 though because I think that if you do find something like that, the retail trader is potentially advantaged. And in general, I think it’s true on a spectrum — the more capacity a strategy has, the more you shouldn’t expect to beat the market with it.
I think of the market as like an ecosystem. If you look at a cubic meter of rainforest, there’s a ton of activity going on at different levels, from bacterium up to tree. Different organisms are taking advantage of different metabolic opportunities of different sizes and types (and their activity provides opportunities to each other). Each creature has its niche.
I think of the market as like that. You’ve got big long-term macro funds taking positions that last for months. And you’ve got little nimble HFT shops making money off of the big slow macro fund’s predictable-on-short-timescales trading behavior.
And I claim the retail trader can potentially find a niche here too. And part of what they should look for are opportunities that are not worth the time of bigger firms. (Though note that this might just mean that this retail trader is currently being undervalued, if they can find opportunities that are worth their while, but wouldn’t be worth the while of an employee at a firm.)
It was my understanding that most of the value that comes from buying the orderflow of a place like RobinHood comes from being able to do high frequency trading. Even if you are a smart trader the people that buy your RobinHood orderflow can profit from you by frontrunning trades.
I’m afraid you’re confused about how PFOF works. It’s absolutely not about “frontrunning trades”
https://public.com/learn/payment-for-order-flow-pfof-explained-and-why-it-matters writes:
To me that sounds like leogao description of the PFOF being due to misinformed traders seems wrong.
I don’t think you’ve found the most unbiased description of PFOF out there