Anatomy of market participants

Paul Samuelson once identified four classes of stock market players:

1. the buy and hold investors, who would do well when economy cycles are on their back
2. "the hour-to-hour, day-to-day ticker watchers", who "mostly make money only for their brokers"
3. the market timers who take advantage of the changing moods of the investing public, and sometimes are successful
4. those who study companies closely enough to take advantage of "special situations" of which public investors are not aware. This is the group makes biggest money.

In today's terms, the first group is still called buy-and-hold investors. The second can be called day-traders, which have evolved from what Samuelson said to more sophisticated groups: high frequency traders and algorithm traders. They trade hundreds of thousands times a day and make money from each trade, even tiny. The accumulated wealth is huge. High frequency traders and algorithm traders are not exclusive. These traders could be very profitable, unlike Samuelson labelled them. The third group includes all kinds of funds, mutual funds and hedge funds. The last group is devoted to merger and acquisition (M&A), which is indeed a stable profit generator.

He himself treated his group (he did invest in commodities) as a new group that use economics and probability theory to make money. So strictly speaking, he was one of the quants. He was also insightful and straight on practical market players' role. When he and his colleagues at MIT's Sloan business school traded commodities back in 1950s, he admitted that they didn't go broke was because the father of one of them, who was a commodity broker, stopped them from doing something craziest. One of his former students, Paul Cootner who focused on fundamental analysis, impressed him by his research between future price spreads and fundamental factors. He agreed in one paper that this fundamental analysis did work.

The identification was done some years ago from now. And it seems the groups didn't get much larger. The clear winner of these groups is the M&A group (had not had the 2008 crisis, the buy-and-hold may be close too).

News broke that a year-to-date largest venture fund was formed in the news:

Khosla Ventures, the venture-capital firm run by longtime Silicon Valley investor Vinod Khosla, closed a $1.05 billion fund that ranks as one of the biggest new venture funds this year, from which it plans to invest a large portion in clean technology.

In closing the fund, the Menlo Park, Calif., firm is bucking two prevailing trends in the venture-capital industry, including an anemic fund-raising environment that has winnowed the number of venture firms that can raise large pools of capital.

It is good hear that a fund specialized on clean technology come out at a time a few renewal energy companies bankrupt. This also brings in needs to justify if this is a right investment decision and timing. No matter what has actually entice investors into this fund, the return seems still in the dark. A more interesting question, why people would invest in uncertainty?

Investment may seek various purposes. Financial planners remind clients that they should prioritize their needs and allocate asset accordingly. It is true that someone may attempt to have more risky investment so that they can get rich quick. On the other hand, some would be elevated if they can get the same yield as Treasurys, securely. These clouds expect different market trends: the first group like volatility while the latter one dislike it. Correspondingly, they would participate or shun volatility. This appears as a negative loop to balance the market. So if we can quantify the driving power of volatility, we can predict where the market is heading.

This was the same idea 40+ years ago how the portfolio theory was born, even though the fundamental of the theory is to maximize return with minimum risk. But again, investment has different goals, thus investment has different paths.

Economy out of daily life (1)

We know that debtors have higher priority than shareholders in bankruptcy cases. Sometimes, due diligence is important to understand what situations we are in before investing.

Joe borrows $100K to start his real estate business. The business starts well and he thinks he can expand it. So he talks to Jane to see if she is interested. Jane indeed is looking for investment opportunities. So she put in $100K to become a shareholder, essentially. They don't have a corporate form. Joe still owes $100K to his debtor. Now the company has value of $200K. The RE market turns down quickly later on. When Joe realizes that the company's value is well below $100K, he files bankruptcy. But he seems not lose anything except his credit: his debtor gets part of investment. Jane, on the other hand, does lose $100K. Joe, after a few years of silence, restarts another business.

This is the case repeatedly happen in investment world: fund managers fold their funds and return remain funds to investors. After a couple years, they would open other funds. Who really get hurts are investors. Therefore, on investors' side, they need to understand the risk. On fund managers' side, they also need to have ability to undertake this risk of withdrawing. John Paulson, the star fund manager, is undergoing a similar situation.

A recent news says that John's funds had almost 50% lost in 2011. Speculations from rivals that he needs to face redemption drives some of his holdings down hugely (his holdings are in public reports). As a sophisticated investor, his funds' major investors are in his company. So it is unlikely he needs to sell everything. But do investors want to stick with him?