11 February 2012

Financial Knowledge and “Free Stuff”: Don’t Get Confused*

Being a self-directed investor is appealing because it enables you to skip all the asset management fees and save a great deal of money from the financial advisors. For a “mass affluent” customer this would make a cost saving of hundreds or even thousands of US dollars or euros within one single year. Furthermore, your carefully selected investments could possibly perform much better than an investment fund or the portfolio composed by an average money manager – because no one cares more about your money than you do. Yet there is the trick: buying and selling stocks and every other sort of financial instruments is now easier than ever, but you have to know what you are doing.

First, you have to have a general understanding of the logic of finance and how the economy works. Secondly, you have to know what a particular financial instrument actually is. (Indeed, trading platforms enable everyone to trade with the funny instruments that basically represent zero-sum games. Unfortunately, many clients or “players” don’t even get what they are actually buying and selling there. The sellers of a trading platform's services sometimes argue that you don’t know how a computer works, either; so just trust the technical indicators. It’s not convincing, it’s nonsense. If the computer doesn’t work, you can go and claim. If a bet doesn’t work, there are no guarantees. Let’s use the common sense: a Wall Street Casino cannot be construed otherwise than on average cheating the “players” – otherwise it would go bankrupt.) Thirdly, the performance of every financial instrument or economy depends on the performance of the underlying asset, were it a common stock, a debt instrument of a company or a government, a housing loan or whatever; you have to understand what the underlying asset or business actually is.

Fine, let’s get know what we have to know. Today, there seem to be numerous free sources of financial knowledge and information for a self-directed investor. This is just a shortlist: websites of financial news channels and online versions of the financial newspapers (ok, this information is free only to certain extent), countless financial blogs and websites, thematic social networking groups etc. Indeed, your broker even gives you an access to the research reports by some bank or rating agency.

Despite of all this “free stuff”, professional investors are still spending a considerable amount of time/money for a thorough research work. (And I’m talking about the professional investors, not those who sound great but when you are looking at their numbers then these are flat.) Why? Why are they not happy with the “free stuff”, especially when assuming that they have accounts by several brokers and thus have access to more research reports and knowledge than a simple small investor does?

There are several good reasons for this.

They are seeking “Alpha”. By definition, the widely available “standard” research does not enable better than average performance.

  • Everyone can access „standard reports” via E*Trade, via their bankers, via the websites of rating agencies etc. This knowledge is already included in the market prices; it does not provide you with an advantage above the market average. Market average is not a satisfactory performance for the professional investors.

The Wall Street equity research potentially misses many great companies.
  • The Wall Street equity research has become focused on big cap, very liquid stocks and ignores the majority (arguably over 60%) of publicly traded stocks. You know, why? In order to remain profitable, the Wall Street firms have to focus on big-cap stocks to generate highly lucrative investment banking deals and trading profits.

Far too often, conflicting interests result in the freely available research that classifies as “promotional”.
Don’t make illusions: a thorough research means a lot of work. Indeed, it may take weeks or even longer. Somebody has to pay for this work, right? For example:
  • Far too often, the payer is the company that is being researched (directly or indirectly; the financing schemes are complicated indeed, so that a retail investor can get confused very easily). Apparently there is an issue of conflicting interests. Have you ever thought why there are sell-side analysts and buy-side analysts? Have you ever thought why there are different analysts for those who are selling securities, and for those who are going to ultimately buy them (such as the institutional investors)? Well, at least a part of the answer is “mistrust”.
  • Brokers and online trading platforms earn their revenues from your trading activity. The more often you buy or sell, the bigger their revenues. So, what kind of research works you possibly access “for free”? Of course the reports that include “buy” or “sell” recommendations directing you to trade far too much (i.e. buy and sell far too frequently).

Clearly, there is an issue of censoring or self-censoring of the knowledge.
  • As an analyst working for a large company, you really cannot tell (or at least, it’s extremely difficult to tell) that a rating agency is wrong or that your competitors are wrong even if you do think so.

The freely available information clearly tends to be far too superficial:
  • The freely available information includes very little if anything about the assumptions of the forecasts. What are the assumed trends in the macro economy? What are the assumptions about the steps taken by central banks and the financial regulators? What effects such actions or inactions may have to a given economy / industry / company? These are crucial questions indeed; however, far too often it remains unclear whether and how they have been included in the analyses.
  • Often the analysis is told to be compiled based on “our proprietary models”. As an outsider, you don’t know what these models really are. Usually a “model” sounds advanced but has very limited capabilities when it comes to forecasting social, economic and financial affairs.

Professional investors know those things. The others usually don’t. But don’t get confused: there is no such thing as free financial knowledge. 

* Disclosure: Except that I do consider myself as a “freak” with a mission to bring clarity into the financial affairs, I do have a materialistic interest when writing this article. Namely, my intention is to make professional financial knowledge accessible and affordable to the retail investors, but I’m going to charge a moderate commission fee for this service. That’s just the reality: the donation button on the left panel really doesn’t work, but in a money-based economy everyone needs some financial resources in order to survive.

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