You are so intelligent. You have a great trade idea and know it will be a winner, but there is only one small problem. For any trade you make, there must be someone else on the other side. For every buyer, there has to be a seller. So, for what you are doing right, someone must do something wrong. That may not be precisely true, but any trader should work under the assumption that his smart money is taking advantage of less intelligent or “challenged” money. What is your advantage when you make a trade? We have looked at this in “The three ways hedge funds make money,” but I find using the acronym BAIT, developed by Michael Mauboussin in “Who is on the other side?” a great way to describe this issue. The acronym BAIT stands for the possible advantages of a manager: Behavioral, Analytical, Informational, and Technical.
B – Behavioral
Opportunities are based on the behavior of others who make mistakes that lead prices to diverge from value. If enough investors engage in behavioral biases, there are opportunities for those who avoid these biases. Mr. Market can act irrationally, albeit it may be hard to know when this will occur. Taking advantage of behavioral bias still needs a sense of value. Nevertheless, behavioral biases may create patterns in prices that can be exploited.
A – Analytical
The advantage associated with analytical skills is the ability to interpret or weigh information differently than the rest of the market. Much information is publicly available, so analytical skill is the ability to use the information available to all differently to achieve better returns. There is an advantage with the better processing and weighting of information versus others.
I – Informational
Acquiring better information is hard in the current markets. There are restrictions on disseminating private information, but new information is becoming available. An information advantage can come from the speed of use, and there is an advantage from using obscure information. There is gain from the aggregation of new and existing information.
There are technical inefficiencies that arise for reasons that are unrelated to new market information. Informationless trading, such as rebalancing from additions and withdrawals, creates profit opportunities. Passive adjustments can provide liquidity or need liquidity from others. Similarly, regulation changes will lead to rebalancing that offers those unaffected by the regulation opportunities for profit. For example, new restrictive bank regulations may offer investors opportunities to provide investment capital—flows based on reasons other than further information.
BAIT is simple when you consider taking a trade as the question of what BAIT I use to gain an excess return.