As a general rule, the average person should think about asset allocation only a handful of times: the first time they make enough money to put some of it aside for later, any time their expected income goes way up or way down, and then one more time when they retire and set-and-forget for the last time.

In practice, you're probably not reading this because you want to invest (110 minus your age)% of your money in stocks and the rest in bonds. If you want to do better—or even if you just want to have a keener appreciation for the people who do—it helps to think carefully about the question of where it should be possible to beat the market, and who would be in a position to do that.

The first two things you should conclude from thinking about this for a minute:

1. It's very, very hard to have a meaningful edge in liquid markets. If you're betting on S&P 500 stocks, major FX pairs, rates, commodities, etc., you're betting against some incredibly sophisticated counterparties. Some of these counterparties are looking at fundamentals—they have meetings with management and they spend a lot on real-time data sets. Some of them are looking at short-term changes in sentiment, and they spend a lot of their time talking to other people and figuring out what positioning is (if you're right that a company will beat sell-side revenue estimates by 2%, but the consensus among pod shops is that the real number is 4%, you can feel gratified that you were right but still lose money if the real number turns out to be 3%). On shorter trading timelines, there's active competition for the privilege of being on the other side of small buy and sell orders.¹

2. If you don't have an edge, the main thing that determines how badly you do will be how frequently you trade. Trading has a cost, even if commissions are free—you're still either putting in market orders and paying to cross the spread (e.g. if a stock is trading at about $10, you might be buying for $10.02 and selling for $9.98, and if $10 is a good guess as to fair value then on average you lose 0.2% every time you trade), or you're putting in limit orders and dealing with the curse of adverse selection: the smarter your order was, the less likely it was to get filled. In that ~$10 example above, if you put in an order at $9.99, then that order won't be filled if you're right about the immediate direction of the market and the stock goes straight to $10.10, but you will place your trade if you're wrong and the stock drops again.

Poker players sometimes talk about how most of the upside comes from picking the right people to play against: "If you can't spot the sucker in the first half hour at the table, then you are the sucker.” Investing is no different; if you choose an easily-accessible venue and trade things people have heard of, you’re opting into competing with some very smart, well-informed people, and you’re probably the sucker. 

You can work backwards and ask where professionals would be reluctant to trade. Successful traders gather assets, so one place to look is anything too small to get their attention. There's a whole universe of microcap stocks out there that big funds don't want to touch, because they can monetize a correct prediction about a 5% move in a megacap stock more effectively than they can a 50% move that finally pushes a company's market cap above $100m.

But be careful! Small-cap stocks are priced less efficiently than big ones, but:

• Especially at the very small end, they're subject to more chicanery than big stocks; if they're too small for activist investors to really care, then you can run into cases where you buy the stock at $5 knowing that it owns assets worth at least $15/share, and then discover that the chairman has generously agreed to buy the whole company for $6/share.

• It's not uncommon for professionals to trade smaller stocks in their personal accounts. If it trades $100k a day, it's not going into a pod shop portfolio (except for systematic strategies that trade a little of everything). But $100k a day is enough volume that someone might chuck some of their bonus money into it, especially if they have access to lots of market depth data from Bloomberg, know how to whip up a model, and can use some of their datasets to triangulate things.

• Small companies are small for a reason. Which is not necessarily bad! The US has lots of tiny publicly-traded banks, many of which have zero analyst coverage and will sometimes end up being too cheap. But when you invest in one, you're implicitly making a bet that there's a reason they haven't sold to a big competitor and this reason won't impair your returns.

In other markets, there can be more opportunities because the market in question is new, illegible to institutions, and legally tricky. Not too long ago, all of crypto fit that bill, and there are still corners that do. Even if you don't have the same risk profile as a prop trading firm that isn't going to risk a billion dollars in tradfi P&L in order to make a million dollars a year trading in some shady offshore venue, you do run some risk there, and that risk is hard to underwrite. These days, prediction markets are all the rage, though even those are starting to draw institutional attention.

Markets tend to be fractally efficient. If a market is easy to trade in, it's very hard to get repeatable alpha, and at the limit, profitable trading looks a lot more like running an operating company—if you're doing high-frequency trading, or have a bunch of teams running uncorrelated strategies, you have fixed costs for infrastructure and support, and those costs will rise over time. There's room to use similar approaches in less liquid markets, but the paradox you run into is that if you do a great job in those markets, you're all tapped out. Markets impose the Peter Principle on everyone: if you're small enough that you can compound your money fast, pretty soon you'll have enough that that compounding slows down. And if you run the numbers, a buy-side job involving more liquid investments plus putting your bonus into boring index funds probably pencils out better—if you're going to be a small solo investor, do it because you love it.

The Diff has looked at how professionals trade, and how trading gets presented to retail:

• Handcrafted artisanal liquidity provision describes the phenomenon where big firms got started betting on a small-scale anomaly. (But beware! One such opportunity highlighted in the piece is waiting for companies to do a tender offer or reverse split and buying a small enough stake to get cashed out. But every so often, companies get annoyed at how many people are doing this, and change their minds.

• Here’s another look at small scale strategies growing into a big financial business.

• One advantage big funds have is alternative data ($).

• One of the risks and opportunities in small-cap stocks: brokers will produce shoddy, conflict-riddle research ($).

Join the discussion!

1  This is not necessarily because retail investors are going to be wrong over the long run, and more so because market-makers will tend to exit positions quickly and their big question is whether your order will be followed by many more in the same direction.