The Real Winners of the Stock Market
It is a common practice to invest into the stock market because we are told that the US economy has busts and booms while always making higher highs. In addition, there are many different approaches that the average person can take to make money in the stock market. The traditional approach is modeled by the likes of Warren Buffett who grew his wealth over years and years of investing in industry-leading companies and reinvesting those dividends. A more recent method or modern approach to making money in the stock market is modeled by celebrity-investors who promote the “get rich quick” scheme to entertain or mislead an audience. But, however you approach the stock market, there is always a winner and a loser in a transaction since for every buyer there is a seller and for every seller there is a buyer. In spite of that, why is there an expectation for the average person to create wealth in the stock market? The answer is written in code by banks and hedge funds alike.
To preface, there are two categories of people who participate in the stock market: smart money and dumb money. Smart money is a term that describes banks, hedge funds, and wealthy individuals whereas dumb money describes the common investor. The discrepancy between smart money and dumb money is that smart money has access to trading or information unavailable to the public and has the capital or liquidity in order to disrupt the market. Dumb money is outmatched by smart money and this is evidenced by the fact that around 90% of all investors lose money in the stock market.
What sets apart the average investor from banks and hedge funds is that banks and hedge funds have immediate access to all sorts of information that brokerages cannot and do not release to retail traders. For example, there are tools that smart money uses that give a deeper lens into the market and how retail traders are transacting. With this information, they can create mathematical sequences that can calculate the greatest loss for retail traders. There are also methods for institutions to see information quicker than average traders so they can make better time-based decisions. Essentially, the cards are stacked against dumb money and dumb money has no idea what the smart money knows and how much they know.
Today, there are many investors who don’t know the secrets of institutions and how they are so successful in trading stocks. The secret is defined by code–literally. Ever since the conception of trading stocks on the digital market, there have been algorithms that were designed to steal the liquidity of the common investor. These algorithms have grown and become more complex and are now referred to as high frequency trading or HFT’s. These HFT’s use fibonacci sequences that are found naturally in the laws of math and statistics and transact large numbers of orders in a fraction of a second. There are a myriad of HFT’s and they can even trade against other HFT’s but, essentially, retail traders are trading against supercomputers.
An example of how an HFT may be used is when the algorithm is triggered during a certain market condition. There may be HFT’s working under a condition that a certain number of relatively small position sizes hits the buy button–indicating that retail traders are active–the HFT sells immediately against the retail traders with much more liquidity thus driving the market down and realizing losses for the retail trader. However, as the retail trader in this situation, it is very difficult to tell when an HFT is trading against investors since there is little transparency in the market. But, for more transparency for the retail trader, there is a method to see the buying and selling pressure of a stock using the “time and sales” function that most brokerages provide for their traders. Basically, time and sales displays the exact time of a buy or sell transaction and the exact quantity of stocks sold. Using this tool, traders can attempt to see who is holding the liquidity and what they plan to do with it, although without much certainty and much success.
Smart money has the liquidity to drive up a market or push it down to considerable levels. Imagine being in control of millions and millions of dollars, how much influence can you have when compared to just hundreds and maybe thousands of dollars as that of a retail trader? Since smart money has so many shares of a stock that they can either buy or sell, they cannot always buy or sell all at one time or else there may be no one else on the other side who is willing to transact at that price. That is why position sizing is crucial in the market. Going back to the time and sales tool, retail traders understand that an arbitrary buy order of 5,000 shares of Stock XYZ is coming from smart money since retail traders trade with 1–100 shares. Smart money, knowing that their position in the market is exposed, then uses different HFT’s that buy Stock XYZ with smaller increments like 100 different orders of 50 buy orders of Stock XYZ. In total, smart money still purchases 5,000 shares of Stock XYZ, but a buy order of 50 in time and sales indicates that a retail trader is getting in on the trade. But, some HFT’s have developed a code that can efficiently group multiple orders and locate them to a single source. In this example, HFT’s may be able to identify that the 100 separate 50 orders of Stock XYZ are coming from a single origin.
As advanced as HFT’s are, HFT’s do not function as artificial intelligence. For every HFT, there is an individual who “switches on” the algorithm; and, this also implies that this algorithm can be switched off. Smart money has the responsibility to run these HFT’s to create a market for both buyers and sellers. There are multiple ways to identify the direction an HFT is trading, but that is a very nuanced subject that only few know. Yet, prominent individuals and more advanced traders have developed strategies to mitigate their risk and trade on the same side of smart money, and smart money never loses. There are far too many “brilliant” and “money-churning” strategies out there from gurus or fake gurus that assert their plan being the best. My advice would be to consider these strategies and back test them rather than blindly following them. But, if smart money never loses, how does the retail investor or “dumb money” profit? The answer is they often don’t.
Goldman Sachs is one model investment firm considered smart money that doesn’t lose. In 2022, Goldman Sachs said its traders cracked the $100 million mark at least once every other day in the first quarter. They report that the trading division profited $100 million in revenue on 32 separate days and this run was the best since the first quarter of 2011. But, where did this profit go? In 2022, Goldman’s stock dropped from $389 per share on January 4, 2022 to $345 per share year to date. If Goldman’s trading desk was breaking records and bringing in billions of dollars of revenue, why then does the stock price not reflect it? There is a multivariate answer that involves their business approach, but the fact that Goldman was highly profitable on their trading desk, yet showed a backpedal in total stock value is not an encouraging sign for retail investors looking to purchase a share of Goldman Sachs.
Even back in 2009, Goldman Sachs reported a 97% win rate (the percentage of wins to losses) with its trading desk. Although Goldman did not release their trading strategy or the risk to reward ratio, this is an incredible feat nonetheless. To put this into perspective, a trader is profitable so long as they make money, regardless of how low their win rate is. If a trader wins 40% of the time and has a risk-reward ratio of 1:10, then for every 10 trades they will lose 60 times variable x (position size) and will profit 400 times variable x. This figure is ideal, but not realistic. On average, retail traders implement a risk to reward ratio of anywhere between 1:1.25 to 1:3. With a much smaller risk to reward ratio, it is imperative that retail traders win more often than not in order to make money or at the very least break even.
Insider trading is more common than you think, but dumb money or retail traders have no way to get in on the gamble, meaning that there is a disproportionate amount of smart money who practices insider trading compared to retail traders. The numbers indicate that there are four times as many insider trading within mergers & acquisitions than there are insider trading prosecutions. Insider trading is unlawful and occurs when no fiduciary duty is present since it gives an unfair advantage to the person presented with the information. If insider trading is illegal and there are laws that would highly discourage people from insider trading, why is it so popular? Simply put, money talks. When gains in the stock market can reach four to five to even six digits, most people won’t think twice and bet for/against a stock using insider information. As they say, it’s only illegal when you get caught.
With the odds hardly ever being in the favor of retail traders, why then is it mainstream to invest in the stock market? Robert Kiyosaki, author of Rich Dad Poor Dad would argue to invest elsewhere than the stock market. A big advocate for debt, Robert Kiyosaki would advise all to invest in gold and silver and to bet against the Fed. In other words, Kiyosaki believes that the Fed is corrupt and that the stock market is a great big bubble. This is not to say that Kiyosaki has 0 assets in the stock market, but that his main focus on investing is in tangible assets like gold, silver, land, and livestock to name a few. And, at 75 years old, Kiyosaki is estimated to have a net worth of $100 million dollars and is definitely credible as his wealth advocates his strategy.
Again, there are so many different ways to invest in the stock market. To mitigate risk, it is safer to bet on the overall growth of the stock market and invest in equities like the S&P for example that is a basket of the top 500 companies on the market. With a simple investing strategy of constantly dollar cost averaging or DCA (as Warren Buffett puts it) which means to continue to buy shares of a stock on a consistent basis, it is likely that you will see gains in the longer term. There have been multiple stock market crashes, the most recent one being the Covid flash crash, but the market always seems to pick itself back up. The stock market is a raging bull market and has seen a return of 9.89% year over year for the last 30 years. In all honesty, a 9.89% return is not a sexy return. It doesn’t turn $10 into $1,000,000 let alone even $100. But, investing is a long term strategy that grows wealth at a pace higher than inflation.
Does this mean that this is the perfect investing strategy? By all means, no. DCA is suitable for individuals that have lower risk tolerance and for those who want to hedge their money against inflation which currently rises on average 3.8% since 1960. It is highly encouraged to do your own research when it comes to investing and to talk to licensed professionals in order to come up with individualized strategies. Overall, there is potential to create wealth in the stock market. And, the right approach will one day lead to an invitation to the 10% of individuals who profit from the stock market.
References
How much insider trading really happens in US stock markets? University of Technology Sydney. (2021, March 23). Retrieved April 29, 2023, from https://www.uts.edu.au/news/business-law/how-much-insider-trading-really-happens-us-stock-markets#:~:text=They%20estimate%20that%20insider%20trading,than%20there%20are%20prosecution%20cases.
Inflation rates in the United States of America. Worlddata.info. (n.d.). Retrieved April 29, 2023, from https://www.worlddata.info/america/usa/inflation-rates.php
TraderMark. (2009, August 5). Goldman Sachs’ 97% win percentage possible but not probable (NYSE:GS). Seeking Alpha. Retrieved April 29, 2023, from https://seekingalpha.com/article/154074-goldman-sachs-97-percent-win-percentage-possible-but-not-probable
What percentage of investors lose money in the stock market 2022. BusinessDIT. (2023, April 20). Retrieved April 29, 2023, from https://www.businessdit.com/statistics-on-investing-money/
