In order to survive and profit in financial market trading, it is necessary to achieve a more accurate pricing of the risk-return ratio than the market, and then trade based on the risk-return ratio. The so-called "pricing" often only pursues a vague correctness, and obsessing over precise pricing only consumes time in searching for errors. Specifically, a profitable trade requires a vague and correct answer to the following three questions:
- Does the individual have a correct understanding of the investment target?
- Does the market have a mistaken understanding of the investment target?
- How long will it take for the market to correct its mistaken understanding, and can the position survive until the market corrects its understanding?
The difference in understanding between individuals and the market leads to differences in pricing of investment targets. Pricing differences can infer potential profits and risks, and are also the source of alpha for excellent investors/traders. Question three can be used to measure whether the return on investment meets personal expectations and to assist in improving position survival capabilities. The first two questions are the key issues that require the most attention in trading. In most fields, answering the first two questions is extremely difficult, and it is even difficult to solve them after investing years of effort in learning and expanding one's capabilities. Therefore, it is often practical wisdom to recognize the limitations of one's own understanding and compromise and give up on certain topics.
Does the individual have a correct understanding of the investment target?#
Having a correct understanding of the investment target means pursuing a vague correctness. When we talk about "understanding," we are actually pursuing the future growth of free cash flow of the investment target. However, the target can only obtain more free cash flow from the operating world if it has better bargaining power (individuals are the same). Understanding bargaining power (and its changes) requires a deep understanding of specific business, competition, and human nature.
- Is there competitiveness in terms of information? Or at least fair competition?
- First, determine the information gap before discussing correct understanding: it is difficult to gain an advantage in understanding when there is a significant difference in information quality.
- How to determine that there is no obvious information gap with the market? When communicating with other investors who have pricing power, most factual information is already known.
- Two underlying elements for achieving correct understanding: continuous learning (a changing world) and respect for human nature (unchanging things).
- Does understanding respect common sense, human nature, and business logic?
- Always consider one's own limitations and think from the opposite perspective of one's own views.
Does the market have a mistaken understanding of the investment target?#
Understanding the market primarily aims to identify the core factors that affect the price changes of the target. When the market trades with incorrect views, we have the correct views in the opposite direction, and finally, the market corrects its mistakes to achieve alpha in an investment.
Where does market information come from?
- Consider the authenticity of market information; the higher the cost, the higher the authenticity.
- Different people have different paths to obtain information: on-chain information, interviews with experts/investors, social media, insider information.
- Price trends and trading volume represent the most important market views, and price-volume information is often low-cost and high-authenticity information that ordinary people can access.
- Large-cap targets need to avoid one-sided information sources, such as viewpoints obtained from a few investment circles. Social media may be a better source.
- Small-cap targets often have fewer market information sources and require entry from circles that have pricing power.
Understanding and comprehending the market can be approached from the perspectives of three types of people, which can help understand why the market is currently priced as it is and how it may be priced in the future. It also helps identify areas where one's views differ from the market.
- Holders: Development of the target, profit expectations, valuation logic, risk preferences, and key risk points of concern.
- People who pay attention but do not hold: Core reasons for not holding? What changes would lead to buying or increasing positions?
- People who do not pay attention: Why do they not pay attention? Would they consider buying after paying attention? Sometimes incorrect pricing is simply due to lack of attention.
- Understand risks from the perspective of holders and profit potential from the perspective of non-holders.
Other points in market understanding:
- Market intentions are often clearer during significant price fluctuations.
- The market makes fewer mistakes. Thinking that the market is wrong often requires thinking from the opposite perspective.
- Linear extrapolation is a major source of market errors.
- Think more about risks that are not priced by the market to better understand the downside.
How long will it take for the market to correct its mistaken understanding, and can the position survive?#
Why should we consider how long it will take for the market to correct its mistaken understanding? The reason is that we are pursuing annualized returns, and the time dimension is related to the word "annualized."
- Why does the market make pricing mistakes? For example, panic, low attention, biases, different reasons require different lengths of time to correct mistakes.
- What will be the catalyst for correcting mistakes? For example, turning losses into profits, increasing share buybacks, increasing dividends.
When should we consider whether the position can survive?
When there are no liabilities holding the assets, there is no need to consider the survival of the position in the face of volatility. However, if leverage is involved, such as using leverage or shorting, the ability of the position to survive in volatility and over time becomes a factor that must be considered.
- One of the essences of volatility is liquidity.
- Most of the time, liquidity is abundant, but during extreme panic and optimism, the market may experience a lack of liquidity. Can the position survive in extreme situations?
- Are the chips highly concentrated in a few people? The difficulty, cost, and cost-effectiveness of their influence on prices?