Two sides to every trade

Posted by on February 18, 2014 @ 1:00 pm in Investing

Suppose, after reading a favorable article on a company, you go out and buy the stock at $10 per share. A year later, the stock price reaches $20, and you close out your position, doubling your money in a year—a savvy investment move. You feel good about your investment acumen.

But that’s not quite the full story. In any financial market, it takes a buyer and a seller to set a market price. There’s always someone else on the other side of a trade. When you bought the stock at $10 per share, the investor selling to you was thinking the stock was no longer worth holding. When you sold your position at $20 per share, there was a buyer on the other side of the trade thinking about the value inherent in the stock—value you no longer saw. Looking at the full picture, including both sides of each trade you made, maybe your “insight” seems a bit more like “luck.”

This notion—that every trade has two sides—is trivially true in financial markets. But it’s also a quite simple idea that offers us several lessons and, in my view, is a hallmark of investment sophistication.

The power of humility, skepticism

One lesson this duality teaches is investment humility. Whenever you make an investment—whether it’s buying or selling a stock, bond, mutual fund, ETF, gold, real estate, you name it—it’s good to remind yourself that someone else, the person on the other side of the trade, takes an entirely different view of the opportunity than you do. You might be buying into a stock index fund because the future looks rosy for the economy and markets. But the person ultimately selling a basket of stocks to you (via the mutual fund) has a different view. You have your convictions; so does the opposite side of the trade.

Another lesson this idea teaches is skepticism. A few years back, I remember an analyst touting water company stocks in a TV ad. The idea (as I remember it) was that environmental pressures and growing agricultural, industrial, and household demand would make water company stocks a smart investment. In this case, the analyst was recommending the fund he advised. Yet as I listened to the ad, it occurred to me that somewhere there was another investor taking exactly the opposite point of view—namely, at current prices now was exactly the time to be selling water company stocks.

This idea also gets to the heart of the debate over active versus passive investing. It’s not that active portfolio managers don’t have great ideas for the stocks (or bonds or other assets) they buy or sell. (By the way, this is true whether the active manager is with another firm or managing one of Vanguard’s many active funds.) But in order to create a great track record over time, active managers must be consistently right on hundreds of buying and selling ideas each year—and thousands over a decade. They’re often smart and hardworking. But so are the people on the other side of the trade. As a result, the odds of consistently being right on hundreds or thousands of investment themes is very hard. And that’s before you deduct the higher fees needed to come up with all of these ideas.

Consider the underlying value

The idea of two-sides-to-every-trade also sheds light on the current debate about alternatives to traditional indexing known as smart beta. In a traditional index fund or ETF, stocks are held in proportion to their overall value in the marketplace. Smart beta advocates say this is backwards: why have large weightings in the largest and most successful companies in the economy? And the short answer is: Look to the other side of the trade. For every investor saying that Apple or Exxon are too big in value and should be sold, there are investors on the other side saying, look how valuable their underlying business franchises are. Companies are big in traditional index funds because the market, buyers and sellers, say they should be—not because Vanguard or any other index manager thinks so.

Next time you’re thinking about making an investment move, remember the two-sides-to-every-trade argument. It’s a useful way to reframe the investment decision, injects an element of realism and truth-telling, and helps combat the tendency toward over-optimism underlying many of our financial decisions.

Notes:

All investing is subject to risk, including the possible loss of the money you invest.

Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.

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