When thinking about any investment, use BAIT to ask questions. BAIT is the acronym developed by Michael Mauboussin in "Who is on the other side?", and is a great way to describe this important issue. For every buyer there is a seller so any investor should ask why anyone should be on the other side of a trade. The acronym stands for the possible advantages of a manager: Behavioral, Analytical, Informational, and Technical.
Behavioral - What is the market telling us through investor behavior?
Market price action is driven by the behavior of market participants. They are subject to a host of biases, so an investment has to understood relative to the biases that may currently be driving price action. Are forecast being extrapolated? Is the market focusing on just recent information? Is sentiment far from normal? This behavioral information may help with mean-reverting trades and where there are large risks of being wrong for a rational contrarian view.
Market price action is driven by the behavior of market participants. They are subject to a host of biases, so an investment has to understood relative to the biases that may currently be driving price action. Are forecast being extrapolated? Is the market focusing on just recent information? Is sentiment far from normal? This behavioral information may help with mean-reverting trades and where there are large risks of being wrong for a rational contrarian view.
- Are investors just extrapolating their perceived forecast skill? Are their forecast based on general knowledge, "news"; special information like brokerage analysts, or private forecasts?
- Is there performance chasing of asset returns? Is selling or buying based on trend or momentum?
- Is there too much consensus among analysts? Is everyone thinking the same?
- Is current sentiment at extremes?
- Is there a correlation of expectations? Is a sell-off based on a general market perception?
- Are there deviations from well-defined value models? Are these deviations going to reverse?
Analytical - What is the level of complexity for the investment?
More complex investments have fewer potential buyers and sellers. There is value with understanding investment complexity, but this also means that you will eventually have to find someone to buy this complexity from you at a favorable price. Perhaps it is better to invest in complex markets that are not perceived to be complex. More complex investments are less liquidity because there are fewer knowledgeable investors.
More complex investments have fewer potential buyers and sellers. There is value with understanding investment complexity, but this also means that you will eventually have to find someone to buy this complexity from you at a favorable price. Perhaps it is better to invest in complex markets that are not perceived to be complex. More complex investments are less liquidity because there are fewer knowledgeable investors.
- How complex is the investment?
- If you have to sell, who will be the potential buyer and how smart does he have to be to make the purchase?
Informational - What is the information missing from the market?
Information is a commodity whose value is variable. Public information released by the government by definition may have less value than information that in manipulated or constructed by a manager. For public information, the value is in the surprise. Public information value is dispersed quickly while private information may take longer to infect a market. As an investor, are you using all of the information that is available and do you have access or employ information that is not embedded in prices or used by others? There is value with manipulating information in a novel manner.
Markets may weigh information differently than you, so a real question is whether the market will come to agree with your weighing assessment. Understanding how information is weighed may be critical to investor success.
- Is the market missing information or not reacting to data as expected?
- Are you paying attention to all information?
- How do you weight information relative to the market?
- Have you noticed changes in the market's weighting scheme?
Technical - Are there technical drivers for market behavior?
Technical factors are associated with endogenous risks, or risks that are associated with market behavior. Fundamental information is exogenous or created outside the market. Investors need to be aware and use both to make successful investment. For example, capital flows provide headwinds and tailwinds for investors. Prices react to stop levels, moving averages, and new highs to name just a few. Technical awareness can make a difference on entry and exit levels.
Technical factors are associated with endogenous risks, or risks that are associated with market behavior. Fundamental information is exogenous or created outside the market. Investors need to be aware and use both to make successful investment. For example, capital flows provide headwinds and tailwinds for investors. Prices react to stop levels, moving averages, and new highs to name just a few. Technical awareness can make a difference on entry and exit levels.
- Are funds flows correlated with performance?
- Is there non-information technical flows pushing markets?
- Are there forced buyers or sellers?
- Are arbitrageurs maxed out allowing markets to react beyond normal?
Once you think of investing as a multi-player game, it will be easier to formulate reactions to your behavior and news. Without a framework it is easy to overthink what markets may do in many situations. Checklists for markets reactions make decisions easier.
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