Fundamental Theorem of Investing Article

[adios]

I think it's good and I basically agree regarding considering the other side of the trade. However I can think of two important reasons in addition why someone may take the other side of a trade when your investment stands to be profitable.

1) This one has to do with the utility functions of the partys involved in the trade and thus their risk vs. reward requirements. In a nutshell, the other party in the trade may be more risk averse.

2) Opportunity costs of the person on the other side of the trade. It may be better for the person to sell to you in order to buy something else that will even be better.

[jively]

If I buy a US total stock market index fund because US stocks are profitable, pay dividends, and grow, do I have to care about the other side of my trades? Options and futures may be zero-sum, but common stocks are not.

-Tom

[jfk]

[ QUOTE ]
If I buy a US total stock market index fund because US stocks are profitable, pay dividends, and grow, do I have to care about the other side of my trades? Options and futures may be zero-sum, but common stocks are not.

-Tom

[/ QUOTE ]

A good example of this is index funds or index shares. What use is there in asking why Vanguard or the AMEX is offering these for sales. An investor is buying because a) the market historically offers a return of X and b) pushing the cost of investing down as far as possible and mimicking the returns of the various indicies is a demonstrable way to maximize that return.

For the majority of traditional, straightforward investment decisions a person makes in a lifetime Sklansky's inquiry would not be a good use of effort.

[Nietzsche]

As someone who is just starting to dabble in the world of investment this gem just reinforces my view that those who have trained themselves to become good poker players have a natural edge when it comes to investing.

[Nietzsche]

[ QUOTE ]
If I buy a US total stock market index fund because US stocks are profitable, pay dividends, and grow, do I have to care about the other side of my trades? Options and futures may be zero-sum, but common stocks are not.

[/ QUOTE ]For index funds this is partly true (not entirely though) but for individual stocks Sklansky's thinking has some value. If you are analyzing a stock and come to the conclusion that the company is worth more than the price of it's stock indicate it would be a good exercise before you automatically hit the buy button to at least try to understand why other's are willing to pay this price. Maybe you have overlooked something. I would be more confident in my buying decision if I could reason why I think others are undervaluing this stock. A more thorough analysis of these reasons might also make you better equiped to hold on to a good stock when everyone else get nervous and sell.

For index funds your argument is better but still not entirely true because sometimes the market is overvalued because of hype. And those times it may be better to delay your buying decision. If you had asked yourself why the market (other people) was hyped up it will make you better equipped to enter at the right time.

[Mr. Now]

Traders perceive and profit from inefficient pricing. Perceptive traders make markets efficient by making perceptive bets.

So you can say that in a market, the more astute and wider perceptions of a relative few players make that market efficient over the short-to-intermediate term. The long term takes care of itself.

When enough traders all exploit a short-term pricing efficiency together, security pricing gets efficient and the move is over.

"Investing" is a loaded term, meaning many things to many people. The DS article seems to be mostly about functioning as a kind of intermediate-term trader, even though the word "investing" is used.

The main problem in sizing up the other side is that there are varied kinds of trade-takers out there. There are institutions, index funds who must buy and sell, position traders, trend followers, market makers, day traders etc. So (at best) you can say 30% of them are this type, 40% are that type, etc on any given day. For example if you buy Intel shares, the other side the trade may be a day trader, or a swing trader, or a trend follower, or an index fund, or a mutual fund. Together they have an extremely wide set of possible motivations for taking the other side of your bet.

You can size up the player population in a market by examining volume, short ratio, mutual fund participation, index and sector funds, etc.

Compared to trading a security, the purchase of a vehicle of home you will own for awhile ("invest in") is a much simpler sizing-up-the-other-side-of-the-trade process.

[derosnec]

[ QUOTE ]
I truly believe that satisfying the Fundamental Theorem of Investing is the most important prerequisite to making a profitable investment.

[/ QUOTE ]

why does he do this so much - make absolute statements (e.g., "most important")? just say "an important prerequisite."

also, no need to use the word "truly" /images/graemlins/wink.gif

[jfk]

[ QUOTE ]
"Investing" is a loaded term, meaning many things to many people. The DS article seems to be mostly about functioning as a kind of intermediate-term trader, even though the word "investing" is used.

[/ QUOTE ]

Excellent observation. The Sklansky article is much better applied to areas that could be considered, trading or speculating rather than "investing" if one considers the word to imply an act with a long term horizon.

[mikechops]

This is a good article, but it reminds me of the joke about two economists who walk past a $100 bill lying on the floor. Their reasoning being that if there really was $100 just lying there, someone would have picked it up already.

Sometimes the answer to why someone takes the other side of a trade, is simply that they aren't as smart as you. If you always need a better reason before investing, you are gonna leave a lot of $100 bills lying there.

[drzen]

[ QUOTE ]
This is a good article, but it reminds me of the joke about two economists who walk past a $100 bill lying on the floor. Their reasoning being that if there really was $100 just lying there, someone would have picked it up already.

Sometimes the answer to why someone takes the other side of a trade, is simply that they aren't as smart as you.

[/ QUOTE ]


"1. He (actually the whole market) doesn’t know or doesn’t understand your reasons."

[riverspecialist]

The article is elegant. It is written ambiguously because it is covers so much. I have tried to explain to people why various trends or wide spread falacies are wrong. Too often the ideas are just too complicated and dont trust me (or them selves) over experts. This article points to a red flag that could prevent many of their bad investments or bets.

I often refer to the economist joke when people are being unrealistic, but really the theory holds true here. The reason the "other side" hasnt picked up the $100 bill yet is because no one saw it. If you see a $100 bill laying on the ground and 10 people are looking at it but not rushing to pick it up, would you? If you want to take this literally then maybe the bill is laying in the middle of a freway, a burning building, over a pittrap, next to a raddle snake, etc. In this case the economist would be right to leave the money there.

I'm tempted to continue about how the 2nd post is silly, but this is just getting too academic. Its not that you dont care what the "other side" is doing, its just that its common knowledge. Companies need capital to grow. On average, a company that is organized enough to go public has SOMETHING of value to contribute to the world and will in all likelyhood make good use of your capital than you would just burying it in the ground. If you ignore the obvious, you can find ways to criticize everything.

[mikechops]

My point is, that if you have done your homework on a stock and are sure you are right, you can always convince yourself reason (1) applies. Worrying about the other side's motives isn't going to help you identify profitable or eliminate unprofitable situations.

Sure, someone is willing to sell you the stock, but on the other hand, somebody else is willing to buy it at a price very close to what you will pay. Why should we assume that the would-be buyer is less knowledgable than the seller? Note, this wouldn't apply if the stock is thinnly traded relative to the size of your investment.

The article applies much more to cases where the other side might reasonably be expected to know more than you. E.g. if you are offered a used car for a suspiciously low price.

[threeducks]

[ QUOTE ]


I often refer to the economist joke when people are being unrealistic, but really the theory holds true here. The reason the "other side" hasnt picked up the $100 bill yet is because no one saw it. If you see a $100 bill laying on the ground and 10 people are looking at it but not rushing to pick it up, would you? If you want to take this literally then maybe the bill is laying in the middle of a freway, a burning building, over a pittrap, next to a raddle snake, etc. In this case the economist would be right to leave the money there.


[/ QUOTE ]

Like too good to be true? Or why is someone offering you such a great deal - I wonder how to apply this to poker? Someone checks to you to give you a free card - maybe he has the nuts and wants you to take the free card to make the second best hand? Or a No-limit bet that is a pure "call me" amount. I guess we need to ask why he is offering me this bet?

[Shandrax]

I like the idea to think about why the other guy is willing to make the deal. Unfortunately the answer "because he is an idiot" will come up so often, that I am not sure if it's really that helpful.

[Mickey Brausch]

[ QUOTE ]
I can think of two important reasons in addition why someone may take the other side of a trade when your investment stands to be profitable.
<font color="white"> . </font>
1) This one has to do with the utility functions of the partys involved in the trade and thus their risk vs. reward requirements. In a nutshell, the other party in the trade may be more risk-averse.

[/ QUOTE ] Precisely. And risk preference is only one aspect of utility functions. Sklansky calls a life insurance policy a "bad bet", but that's only true in terms of expectation. He is right that you should be selling in this transaction (i.e. be the insurance policy seller) but that doesn't mean that the insurance buyer is necessarily making a bad bet.

And there's the matter of certainty equivalent. You are holding 100 shares of stock XYZ that will go up 20% within the next week with probability 50% or drop 10% with probability 40%. We both possess exactly the same information about the stock and the same expreience, knowledge, and intellectual abilities. Yet you would be quite willing to part with your shares for a 4% or 5% premium whilst I'm ready to buy them at a 7% or 8% premium over the current price of XYZ.

Your reasons for selling a little below expetctaion have to do with your CE -- which, in turn, is shaped by a variety or reasons, some financial, others non-financial. Same for me. I'm ready to fork over more than my expectation for a number of reasons. (E.g. I'm managing a mutual fund and XYZ will be part of my little "speculative" harem; I'm a very wealthy man so I can afford to gamble a little; etc.)

[ QUOTE ]
2) It may be better for the person to sell to you in order to buy something else that will even be better.

[/ QUOTE ] Better for him. Precisely.

You're selling your stock in XYZ because you have found a house in your favorite vacation place to buy at a good price and you need the cash. I'm buying your stock because I have recently sold some real estate and I consider the stock market a better investment place for now.

Notice that all the above satisfies Sklansky's FT of Investing. /images/graemlins/smile.gif

Mickey Brausch

[MaxWeiss]

In fact, most insurance companies vigorously pursue lawsuits to reclaim the money they have to pay out. There are also some other things going on, which may make insurance (life, health, though mainly I am talking about CAR insurance) not nearly as bad as one would originally assume given the first initial thought of "well, they wouldn't be in business if it wasn't -EV for me." In most cases, it does not take much increase in likelihood of needing the insurance to make it worthwhile. That combined with the decrease in variance insurance provides makes me inclined to not so harshly judge insurance companies just yet. (I currently have student health insurance weather I want it or not. Not sure what I'll do after school, if I am not at a job that automatically gives it to me.)

I did like the article though. There's a quote somewhere--"In every wager there is a fool and a thief."-- make sure you know which one you are!!! Good advice!