I don’t think the Widgets Inc. example is a good one. Michael Lewis has a good counterpoint in The Big Short, which I will quote at length:
The alarmingly named Avant! Corporation was a good example. He [Michael Burry] had found it searching for the word “accepted” in news stories. He knew, standing at the edge of the playing field, he needed to find unorthodox ways to tilt it to his advantage, and that usually meant finding situations the world might not be fully aware of. “I wasn’t looking for a news report of a scam or fraud per se,” he said. “That would have been too backward-looking, and I was looking to get in front of something. I was looking for something happening in the courts that might lead to an investment thesis.” A court had accepted a plea from a software company called the Avant! Corporation. Avant! had been accused of stealing from a competitor the software code that was the whole foundation of Avant!‘s business. The company had $100 million cash in the bank, was still generating $100 million a year of free cash flow—and had a market value of only $250 million! Michael Burry started digging; by the time he was done, he knew more about the Avant! Corporation than any man on earth. He was able to see that even if the executives went to jail (as they did) and the fines were paid (as they were), Avant! would be worth a lot more than the market then assumed. Most of its engineers were Chinese nationals on work visas, thus trapped—there was no risk that anyone would quit before the lights were out. To make money on Avant!’s stock, however, he’d probably have to stomach short-term losses, as investors puked up shares in horrified response to negative publicity.
Burry bought his first shares of Avant! in June 2001 at $12 a share. Avant!‘s management then appeared on the cover of Business Week, under the headline, “Does Crime Pay?” The stock plunged; Burry bought more. Avant!‘s management went to jail. The stock fell some more. Mike Burry kept on buying it—all the way down to $2 a share. He became Avant!‘s single largest shareholder; he pressed management for changes. “With [the former CEO’s] criminal aura no longer a part of operating management,” he wrote to the new bosses, “Avant! has a chance to demonstrate its concern for shareholders.” In August, in another e-mail, he wrote, “Avant! still makes me feel I’m sleeping with the village slut. No matter how well my needs are met, I doubt I’ll ever brag about it. The ‘creep’ factor is off the charts. I half think that if I pushed Avant! too hard I’d end up being terrorized by the Chinese mafia.” Four months later, Avant! got taken over for $22 a share.
Why should Michael Burry have assumed that he had more insight about Avant! Corporation than the people trading with him? When all of those other traders exited Avant!, driving its share price to $2, Burry stayed in. Would you have? Or would you have thought, “I wonder what that trader selling Avant! for $2 knows that I don’t?”
Or would you have thought, “I wonder what that trader selling Avant! for $2 knows that I don’t?”
The correct move is to think this, but correctly conclude you have the information advantage and keep buying. Adverse selection is extremely prevalent in public markets so you need to always be thinking about it, and as a professional trader you can and must model it well enough to not be scared off of good trades.
That point is contradicted by the wheelbarrow examples in the OP, which seem to imply that either you’ll be the greater fool or you’ll be outbid by the greater fool. Why wasn’t Burry outbid by a fool who thought that Avant! was worth $40 a share?
This is why I disagree with the OP; like you, I believe that it’s possible to gain from informed trading, even in a market filled with adverse selection.
OP was a professional trader and definitely (98%) agrees with us. I think the (edit: former) title is pretty misleading and gives people the impression that all trades are bad though.
Why should Michael Burry have assumed that he had more insight about Avant! Corporation than the people trading with him?
Because he did a lot of research and “knew more about the Avant! Corporation than any man on earth”? If you have good reason to think that you’re the one with an information advantage trades like this can be rational. Of course it’s always possible to be wrong about that, but there are enough irrational traders out there that it’s not ruled out. Also note that it’s not actually needed that your counterparties are irrational on average, it’s enough that there are irrational traders somewhere in the broader ecosystem, as they can “subsidize” moderately-informed trading by others(which you can take advantage of in individual cases)
The second wheelbarrow example has a protagonist who knows the true value of the wheelbarrow, but still loses out:
At the town fair, a wheelbarrow is up for auction. You think the fair price of the wheelbarrow is around $120 (with some uncertainty), so you submit a bid for $108. You find out that you didn’t win—the winning bidder ends up being some schmuck who bid $180. You don’t exchange any money or wheelbarrows. When you get home, you check online out of curiosity, and indeed the item retails for $120. Your estimate was great, your bid was reasonable, and you exchanged nothing as a result, reaping a profit of zero dollars and zero cents.
But, in my example, Burry wasn’t outbid by “some schmuck” who thought that Avant! was worth vastly more than it ended up being worth. Burry was able to guess not just the true value of Avant!, but also the value that other market participants placed on Avant!, enabling him to buy up shares at a discount compared to what the company ended up selling for.
The implied question in my post was, “How do you know if you’re Michael Burry, or the trader selling Avant! shares for $2?”
I don’t think the Widgets Inc. example is a good one. Michael Lewis has a good counterpoint in The Big Short, which I will quote at length:
Why should Michael Burry have assumed that he had more insight about Avant! Corporation than the people trading with him? When all of those other traders exited Avant!, driving its share price to $2, Burry stayed in. Would you have? Or would you have thought, “I wonder what that trader selling Avant! for $2 knows that I don’t?”
The correct move is to think this, but correctly conclude you have the information advantage and keep buying. Adverse selection is extremely prevalent in public markets so you need to always be thinking about it, and as a professional trader you can and must model it well enough to not be scared off of good trades.
That point is contradicted by the wheelbarrow examples in the OP, which seem to imply that either you’ll be the greater fool or you’ll be outbid by the greater fool. Why wasn’t Burry outbid by a fool who thought that Avant! was worth $40 a share?
This is why I disagree with the OP; like you, I believe that it’s possible to gain from informed trading, even in a market filled with adverse selection.
OP was a professional trader and definitely (98%) agrees with us. I think the (edit: former) title is pretty misleading and gives people the impression that all trades are bad though.
Because there were enough people selling for prices lower than $40 to satisfy the demand for greater fools?
Also, stocks can be sold short if the price goes too high.
Because he did a lot of research and “knew more about the Avant! Corporation than any man on earth”? If you have good reason to think that you’re the one with an information advantage trades like this can be rational. Of course it’s always possible to be wrong about that, but there are enough irrational traders out there that it’s not ruled out. Also note that it’s not actually needed that your counterparties are irrational on average, it’s enough that there are irrational traders somewhere in the broader ecosystem, as they can “subsidize” moderately-informed trading by others(which you can take advantage of in individual cases)
The second wheelbarrow example has a protagonist who knows the true value of the wheelbarrow, but still loses out:
But, in my example, Burry wasn’t outbid by “some schmuck” who thought that Avant! was worth vastly more than it ended up being worth. Burry was able to guess not just the true value of Avant!, but also the value that other market participants placed on Avant!, enabling him to buy up shares at a discount compared to what the company ended up selling for.
The implied question in my post was, “How do you know if you’re Michael Burry, or the trader selling Avant! shares for $2?”