Monday, September 14, 2009

On Market Perceptions - Alpha

Vega brings up a good point to distinguish the momentum followers from the intelligent investors and sharp speculators.

Momentum followers look at a rising price trend and create a rationale for why it will continue. Much of the market consensus that Vega mention is simply this. Trend/momentum following, aka herding.

An intelligent investor looks at a stable cash flow series coming from an asset. She then tries to calculate conservatively how the cash flows will grow, and what the risks are that they diminish. An investor needs a fair amount of certainty, but can take risk in making a decision. That is, she needs probabilities and magnitudes of different states of the world that could produce different cash flow outcomes. But after everything is factored, she can build a spreadsheet to assess "intrinsic value" and make a rational decision. Negative price trends, that is, falling prices, are what interest investors, because at some point the price of an asset is so far below a conservative estimate of the asset's intrinsic value that an investor will want to buy it.

A sharp speculator is one who is willing to "bet" with less information than an investor, where the probability or magnitude of different states are unknown. The best speculators have a deep domain knowledge about one area (software stocks, orange juice futures, IG bonds, etc.) and stick to that area.

Yet the line between investing and speculation is a grey zone, since most people aren't omniscient and don't ever truly know whether they have all the information or if their subjective judgments on probability and magnitude are well-founded. Hence as an example, even as an outside observer it's tough to know what to call Buffett's different trades over the last decade - some were speculative like his silver position or his Dow Jones merger arb position or Goldman Sachs slug, whereas others were more like true investments such as his Iscar purchase.

The key to successful investment and speculation is to have a "variant perception." That is, know what the market consensus is and have a strong, well-backed view about why the facts on the ground are different, and how the difference can lead to a profitable trade. Profitable variant perceptions are uncommon.

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