In today’s Exponential Investor…
- Newton’s StockTok account
- The asymmetry of the market
- Know how information applies to you
Isaac Newton would have 100 million followers on TikTok.
I can see it now…
“Trading Stonks is easy my learned friends. For every stonk sold has an equal and opposite stock bought.
He would then proceed to mic-drop and end his “vlog”.
This is what fascinates me most about the stock market right now. It’s also why this week I’ve been looking at the phenomenon of social trading. When you bust through the madness, it’s an incredible look at investor psychology and how to (and not to) trade the market.
You see, the market seems irrational. There’s a fair argument it is. There’s also a fair argument that it’s always been irrational.
However, when you study basic economics and finance you learn what’s known as the Efficient Market Hypothesis (EMH).
EMH is the theory that markets will trade at prices based on all available information. Hence the market prices are fair value and that anomalies outside of this will correct back to fair value.
The idea being that long term, you can’t beat the market. That the only way to generate excess returns over and above “the market” is to have access to information that is not widely available.
EMH has a long, deep-rooted existence in modern financial and economic theory. Many still believe it to be true.
There’s nothing efficient about it
Simply put, the market is asymmetrical. Asymmetrical in that one side of the trade always has an upper hand, a piece of knowledge or information that the other side of the trade doesn’t have.
If both sides had equal information, then we would have rational, value-based, fundamentally sound asset prices. Clearly that’s not the case.
There’s a reason why the like of GameStop, Blackberry… even Nokia are rising dramatically in price on the back of no news. It’s an information asymmetry, nothing efficient about that.
However, the information asymmetry doesn’t necessarily mean good information. And this is where things get really tricky, and interesting.
You see, when you look at some of these stocks that have boomed off the back of StockTok and Reddit coverage, you have to consider something.
There’s two sides to every trade. Just like Newton’s third law, for every action there is an equal and opposite reaction… this is exactly what plays out in the market too.
So when GameStop is up over 100%, trading up close to $160 intraday, that’s not just some made-up figure.
Someone out there in the big wide world sold GameStop stock near $160. Likewise, there’s the other side of that trade – someone bought it for almost $160.
That begs the question, why?
When you see a stock move with such ferocity, you have to ask why it’s happening. You also have to try and comprehend why someone would pay $160 for a stock that’s already up a couple hundred per cent in a short space of time on no news, no fundamental change to the business, nothing aside from social media coverage.
At what point does investor psychology break down so much for that to appear to be a rational trade?
Is there some kind of information bias towards the buyer, do they know something the seller does not?
Or is the information bias with the seller, and they know something, or have information the buyer does not?
In a scenario like that, you have to consider that the seller has the asymmetrical information bias. They know that the main reason for the ratchet higher is no more than “pamp it” on Reddit. And the buyer, you have to assume, while they may be aware of that information, considers that effect has not yet played out in full.
One will be right. One will be wrong. And their information will prove good or bad.
Know your information
As it pans out, the seller in that instance had the advantage. The buyer did not when in the space of minutes, a huge chunk was wiped off the stock, sending it over 50% lower with great speed.
This is just one example – an extreme example – of how markets work. Even though there’s a lot of algorithmic-based trading that takes place, there’s also a significant retail proportion of buyers and sellers. These can impact algo trading as well.
It means that for every trade you make, you have to consider these factors. You have to think about the information you have, and how it has led you to make a particular decision.
What is your information feed that has brought you to buy at stock at a certain price, and perhaps not a lower price? Or if the price shifts higher, does your information support that decision?
Or is it that when you’re ready to sell your information, that warrants a sell decision? Remember, when you sell, someone will buy, and you have to ask what makes them ready to buy your stock when you sell.
Maybe it’s as simple as you’ve made a great gain and you want to realise it. Or maybe it’s cutting a loss because your timing was off. That can be good information, which is specific to you.
However, as a long-term investor, I believe that knowing what kinds of information drives a stock price, what kinds of information buyers and sellers are operating on and where the information asymmetry lies, will help you to be a better investor.
It will mean you might take longer to make decisions, but you will make better decisions. It might mean you watch the drama unfold, and a bit of jealousy kicks in as you watch a stock go bonkers. It might also mean you revel in a decision to take no action that pays off in spades.
Understanding how information is absorbed by the market is key. Understanding how it applies to you and to your decision making is a valuable tool to have. Knowing when the market is trading on bad information and knowing when to sit back and enjoy the show – which takes experience and a great amount of self-control – that’s priceless.
Editor, Exponential Investor