Thirsty? Do you sip at the market’s liquidity or do you gulp it down? By liquidity, we mean the amount of trading volume a stock has on a given day. If $10,000 worth of a stock trades on a given day, and you want to buy $100,000 worth, you’re going to be sad. How do you think about this? I’ve chosen (to match the whimsical title) to divide investors into four groups, each with a sample persona.
1. Rudy trades a few thousand up to about $50,000 per position (he’s investing for retirement). Rudy puts enough money behind each trade that the commission will not be the dominating factor, but he’ll get mugged if he doesn’t pay attention to slippage, and invests in lesser known names. He also, in all probability, didn’t know that he needed to worry about this. If he takes the time to learn about all the issues one can run into while trading the market, he may get scared off, or decide he doesn’t have time to worry about it. And that would be a shame, as there is plenty of money to be made trading sensible strategies, such as this one (which makes 9% annually, versus 4.8% for the s&p 500, assuming a 1% trading cost).
2. For Irene, around $100,000 changes hands every time she pushes a button. She uses Interactive Brokers, or a prime broker, and probably works for a financial institution, or is a RIA. She doesn’t pay much in commissions (perhaps $0.004 per share). On the other hand, she has to worry about much more about slippage (her trades may move the market on smaller issues). She also has extra mandates that we don’t (for instance, to avoid ADR’s or stay out of certain industries), but she can’t tell us what those restrictions might be. Mum’s the word. She can still get outperform the market, even despite her institutional mandates (we assume a 0.5% trading cost, but cut her off of the small cap gravy train):
One thing to note — the universe keyword above affects not only the final screen results, but also the ranking. Stocks that don’t match the universe criteria may as well not exist — they aren’t used for comparisons, and won’t match or be screened. If a stock falls out of the universe, you’ll still get its performance until the next rebalance.
3. Regular people trading much smaller positions. These people may not have to care about taking 10% of the daily volume, but they may not like it much if trading volume drops to zero. They should be very very careful about commissions, and should consider using a top five, or even a top three strategy, because the commissions will eat them alive. They may want to stay away from illiquid stocks because they are going to really want to get into and out of their positions in one go, though they could go smaller. For this article, I assume they pay 2% in trading costs, giving them the following:
Turns out Sam outperforms Irene… Interesting.
4. Pat is happy to trade slowly into a stock, and leave it there for a long time. She’s one of a cadre of patient, knowledgeable people who invest in nano-caps, and take days (or months) to get into and out of a position, sipping very slowly at the market as they build their (presumably larger) positions in stocks that have virtually no volume. The Shadow Stock portfolio AAII publishes is an example of this. Here we take our strategy, and restrict it further — Only companies with a market cap less than 500 million, and with a trading volume less than $500,000. We do want some trading volume, so we ask for $50,000. We also assume Pat rebalances her portfolio yearly, rather than quarterly, and that she pays 2% on each trade despite her best efforts to work into the positions slowly, How does she do?
Very well, it turns out (especially since trading yearly meant she skipped the year 2000 altogether). But wait! What if she can’t get “only” 2% trading costs? What if she has to pay 5%? She doesn’t do so well, but she still beats the P&P 500:
Of course, this strategy has a flaw, and this flaw makes it uninvestable. Completely, absolutely, amazingly unusable for everyone.