Before making any investment, and this would include the buying and selling of stocks, options, used automobiles, or any other merchandise, as well as any wagering, you must do one thing before you can be confident you are making the right play. You may have the most compelling reasons in the world for believing that your transaction gives you the best of it. But that matters little, unless you can also satisfy what I call the Fundamental Theorem of Investing.
To satisfy the Fundamental Theorem of Investing you must be able to explain why the other party is willing to take the other side of the deal. This, in spite of the fact that he or she is supposedly giving you the best of it. If you cannot come up with a good explanation, your buy, sell, or bet is almost certainly not as good as you think.
Now one would think that this Fundamental Theorem is the height of common sense. And in every day transactions, it often is. I’ll sell you my little hold ’em book for twenty bucks even though it will make you thousands, because you might not be willing to pay more, and it only costs me a buck to print. In fact, the vast majority of retail transactions are of this nature. They are simply “win-win” situations where both parties gain from the transaction. So in these cases it is easy to satisfy the Fundamental Theorem of Investing as part of your buying decision. You’re getting a good buy because the seller gains as well.
But what about a zero sum game? Now there can be only one winner. So why does the other guy take the other side? That is the key question. Yet you almost never see so-called “experts” addressing this when they tout their stock, horse, or sports pick. If IBM is such a great buy at $70, then why are others selling at that price? If you can’t answer that, all your other points are almost irrelevant.
Before proceeding, let me say that it is not necessary that you be trading directly with a counterpart for the Fundamental Theorem of Investing to hold true. There may be middlemen, such as bookies or brokers, but someone is still, indirectly, taking the other side. Usually a group of someones.
Apart from win-win situations, there are three possible explanations why someone might be willing to take the other side of a transaction where you think you have the best of it. They are:
1. He (actually the whole market) doesn’t know or doesn’t understand your reasons.
2. He has his own reasons which you believe to be flawed.
3. He is hedging to reduce volatility.
Here are some examples:
1. The most obvious example is when you have inside information. And it doesn’t have to be illegal. For instance, if the Yankees all got food poisoning at your hotel last night. I, for instance, made a nice score in WMS stock because I happened to be there when they first introduced the Monopoly slot machine to the Mirage. If you bet against the Yankees or bought WMS, it was easy to explain why your counterparts would unknowingly give you the best of it.
However, it may be the case that your counterparts or the market have exactly the same information as yourself. Nonetheless, you can still satisfy the Fundamental Theorem of Investing by having an insight about this shared information that they don’t have. Until I wrote about it, it was not well known that an NBA team, having lost its first two playoff games on the road, would usually make a great turnaround in their third game at home. Therefore, betting on them was great as the line didn’t reflect this insight.
Twenty years ago it was simple to find good bets in the options market because people did not know how to factor volatility into the price of an option. Having common sense about internet stocks, while realizing everyone else was irrationally exuberant, is another example.
2. A few years after Charles Schwab started the practice of discounting commissions while giving no advice, a bunch of competitors sprung up. While Schwab had cut full service brokers’ commissions by about two thirds, these other deep discount brokers charged about half that. The thinking was that Schwab was in trouble, and their stock declined. But I bought Schwab stock at that point. It seemed to me that most investors would not want their money held by these small competitors simply to save a few extra bucks. I was right and Schwab price recovered. This, then, is an example of making a play because you know the other side’s reasons, but disagree with them. It can come up in football betting when two undefeated teams meet, where one is the favorite because their previous wins were more lopsided. You believe that is a bad reason, so you bet the dog. In harness racing, you might see that a horse is allowed to go off at good odds because of his fifth place finish last week However, you know that he couldn’t be expected to gain his usual ground in the stretch because of early slow fractions. Thus, you bet the overlay because you understand the reason for it.
3. It can also occur that the other side is fully aware they are taking a little bit the worst of it, yet are willing to do so (thus giving you the best of it) because of their financial situation. When a stock strongly moves up quickly, usually because of some sort of news, many owners of that stock are anxious to sell in order to lock in a profit. Therefore, buying at this point has historically, been slightly profitable. (This may have changed though). Both options and commodities are sometimes bought and sold, not to make money, but to hedge and prevent losses in another position. Usually the hedges will give up some expected value in return for safety, so you gain by taking the other side of the trade. Similarly, if a sports team is up by a lot at halftime, players who bet that team will often try to hedge by betting the other side when the halftime line is displayed. This may mean the line is shaved, such that betting the leader is the better halftime bet. In this case, the Fundamental Theorem of Investing is satisfied because those taking the other side don’t care that they are taking the worst of it.
Of course the best example of people knowingly making a bad bet for the sake of safety is when they buy insurance: Life, health, or betting against themselves when they flop the best hand (at times when all in, for no-limit games). You, of course, should be selling that insurance.
I truly believe that satisfying the Fundamental Theorem of Investing is the most important prerequisite to making a profitable investment. You must be able to fully explain why others are willing to take the other side, even though you think your side is the right one. Of course merely satisfying the Fundamental Theorem of Investing doesn’t mean you have the best of it. But if you can’t satisfy it, all the statistics, income statements, balance sheet data, or analysts’ recommendations mean little. There is still some reason they are taking your bet. And if you don’t know it, you don’t like it.
Dieser Artikel erschien auf PokerOlymp am 26.09.2007.